Will the Euro recovery last?

XM Investment Research Desk: Major currencies were steadier in European trading on Tuesday with the euro and the pound holding near multi-week highs, while the US dollar firmed from yesterday’s 3-week low. The positive risk sentiment from Asia carried forward to the European session with major European stock indices extending Monday’s gains.

Reports that the Italian government was preparing a state aid for the country’s third largest bank, Monte dei Paschi di Siena, helped the recovery in risk appetite following the rejection by Italian voters for constitutional reform in Sunday’s referendum.

The euro hit a session peak of 1.0785 dollars, not too far from yesterday’s 3-week high of 1.0796. The single currency was earlier boosted by a better-than-expected increase in German factory orders, which jumped by 4.9% month-on-month in October. Expectations were for a rise of 0.6% and compares with an upwardly revised 0.3% drop the prior month.

However, rumours that Italy may hold fresh elections as early as February 2017 following the Prime Minister’s resignation weighed on the euro in late session, dragging the currency to around 1.0730 dollars. There was less reaction to Eurozone GDP data. The third estimate of GDP growth for the euro area confirmed growth at 0.3% quarter-on-quarter in the July-September period, though the year-on-year rate was revised up by 0.1% to 1.7%.

Italians overwhelmingly rejected plans to reform the country’s constitution on Sunday, forcing the resignation of the Italian prime minister and triggering a fresh political crisis for the Eurozone. Voters decided against reducing the power of the Senate that would have simplified the process for the government to pass through legislation. However, the outcome of the vote was seen more as a rejection of the Prime Minister’s economic policies than the proposed changes to the constitution itself.

A ‘No’ vote was widely expected as polls in the run-up to Sunday’s referendum showed there was not much support for Prime Minister Matteo Renzi’s reforms. But the final result where the ‘No’ vote lead by 59.4% against just 40.6% for ‘Yes’ took markets by surprise, pushing the euro to a 21-month low. Prime Minister Renzi had already promised he would step down if he lost the referendum but the larger-than-expected margin signalled strong opposition by the Italian public to his government’s policies, thus, increasing the likelihood that anti-establishment parties would do well if a general election is called.

Italy’s President is due to decide later on Monday whether to ask Renzi to stay on (possibly until at least the next budget is approved later this month), or to appoint someone else from the Democratic Party to lead the government until the end of the current parliamentary term, or to call fresh elections. Until then, the euro took a respite to reverse all of its earlier losses, rebounding sharply from its low of 1.0503 dollars to climb to a 2 1/2-week high of 1.0728 dollars by mid-European session.

However, the positive momentum for the euro is unlikely to last if the President, Sergio Mattarella, decides to hold new parliamentary elections. This is because the biggest winners from any election are likely to be the anti-establishment party, 5 Star Movement, which have been gaining in popularity with voters. The 5 Star Movement party strongly favours holding a referendum to decide whether Italy should leave the single currency. The political uncertainty also threatens to destabilize Italy’s fragile banking system. A win by the party in an election would therefore add to the wider uncertainty already blighting the Eurozone and generate renewed downside pressure for the euro.

General elections in the Netherlands, France and Germany in 2017 are being anxiously watched by investors as recent votes in the United Kingdom and the United States have proved there is a growing anti-establishment sentiment among the public that polls have failed to pick up on.

Also on the horizon for the euro is this week’s monetary policy meeting by the European Central Bank on December 8. The ECB is expected to extend the duration of its asset purchase program by at least 6 months and possibly announce tweaks to the parameters of the program. In contrast, the Federal Reserve in the United States is expected to raise rates later this month, further widening the interest-rate differential between the euro and the dollar.

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