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Renzi and Referandum Defeat, ECB QE and European Banking

Italy’s PM Renzi has resigned after losing the Constitutional Referendum by a surprisingly wide margin of almost 20%. Yes, the market was positioned for the ‘Yes’ campaign to lose, but not at this margin, now raising questions concerning Italy’s long-term capability to reform. We believe that the wide margin at which PM Renzi has lost the referendum will not change the near-term outlook for Italy suggesting the EUR should rebound from this morning’s lows. There are three facts to acknowledge when trading the EUR.

First, Sergio Matterella, Italy’s president, will likely appoint a new prime minister to govern the country until the next parliamentary elections, due in early 2018. The premier’s chief task will be to prepare a new electoral law to replace the present system, which awards bonus seats to the winning party and is intended to ensure a government can rule unchallenged for a full five-year term. Changing the electoral law requires an agreement among Italy’s two main centrist parties which is likely and does reduce Italy’s political tail risk, namely of the next election bringing a populist party into power.

 Secondly, Italy will have now make decisions concerning the re-capitalisation of its banking industry, while the ECB will need to deliver its annual Supervisory Review and Evaluation Process within the next three weeks. Re-capitalisation via the private sector would be the preferred outcome, but should the ECB acknowledge deeper capital loss potentials and not credit existing restructuring operations then the Italian government may have to step in. The problem is that households own about EUR170bn worth of bank bonds. EU rules require junior bond holders to bear the losses, suggesting re-capitalisation via the sovereign comes not only at the cost of increasing Italy’s state debt beyond its current 133% GDP, but it would also come at a potentially high political price namely its electorate turning even more populist.

Third, there is a feedback loop between bank balance sheets and the credit worthiness of the Italian sovereign defined by the banks’ 17% claim (11.5% via BTP holdings) of its total assets holdings. Hence, the performance of BTP’s and not bank share volatility will act as the best indicator for evaluating the EUR’s trading behaviour. The BTP outlook depends on the willingness of the ECB to act de-facto as the ‘lender of last resort’ for Italy. This ‘lender of last resort’ capacity is currently defined the ECB’s OMT and QE program.

This puts this week’s ECB meeting into a very special context. We outline the EUR impact from ECB outcomes here. Ex Bundesbank President Weber suggested that the ECB may have to pull the QE program earlier than currently suggested by markets. However, Italy’s instability will make it difficult to lay out a calendar driven QE tapering schedule when it meets this week. Anyway, markets have not anticipated any ECB tapering talk. On the other hand investors fear BTP volatility. The ECB knowing about the linkage between banks and Italy’s sovereign balance sheet will try to curb BTP volatility. Should this volatility stay within acceptable levels then the EUR should rebound too, moving slowly back to last week’s EURUSD high of 1.0661.

This outcome receives additional support from the fact that the EUR has reached key support on some crosses. For instance, EURGBP has tested levels near its 200-day MAV 0.8281 this morning. The outcome of Austria’s Presidential election showing the moderate center left candidate Alexander van der Bellen winning surprisingly convincingly has interrupted the string of populist election outcomes, providinghope in the France Presidential election showing a moderate outcome.

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