Dollar Remains Firm While Italy Is Punished

Overview: The US dollar’s post-Fed gains have been extended, though the upside momentum appears to be stalling. Japan’s Nikkei advanced 1.35% on the back of the yen’s declines and reached its highest level since 1991. Chinese shares (A and H) rallied amid reports that MSCI and FTSE-Russell are boosting Chinese shares in their benchmarks. Chinese markets are closed next week for the national holiday. European shares are snapping a three-day advance with the Dow Jones Stoxx 600 off about 0.3% to halve this week’s gain. Italy is bearing the brunt with more than a 2% decline. European financials are the worst performing sector. Here too Italy is showing the way. Its bank index is off 5.5%, today and 6.6% for the week. The bank index had rallied about 13.5% over the past three weeks. Core European bond market yields are 2-4 bp lower, while Italy’s coupon curve is 25-30 bp higher, after what appeared like successful auctions yesterday.  

Italy: The government inherited a budget deficit target of 1.8% of GDP this year. The League and the 5-Star Movement insisted that people voted for a change and both parties campaigned for some form of fiscal expansion. The League wanted to lower taxes. The MS5 wanted a “citizen wage.” The centrists tried blocking it, but in the end, could not resist and next year’s deficit will be 2.4% of GDP. The Bloomberg survey covering the past fortnight produced a median deficit forecast of 2.2% of GDP. Note that Italy is in a favorable position where it has about two-thirds more bonds maturing than it needs to sell in the next two months. An EU official quoted on the news wires suggested that the deficit should be closer to 1.6% of GDP. This sets up a confrontation with the EU next month. 

Euro: The single currency declined steadily in North America yesterday. The nearly 0.85% decline was the largest in six weeks and took the euro about $1.1640, its lowest level in ten days. There is follow through today. A break of $1.1600 signals a near-term move toward $1.1530-$1.1560. If the euro stabilizes, options expirations may cap its ability to recover. There are 4.2 bln euro in a $1.1630 option that expires today and 1.3 bln euros in options at $1.1650-$1.1655. There appear to be at least four drivers. First, despite talk about the dollar having topped out and Draghi’s “vigorous” comment, the bulls could not establish a foothold above $1.18. Second, Powell left no doubt that the Fed would continue to gradually hike rates. Peak divergence still lies ahead. Third, the protracted debate over the Italian government’s fiscal stance injected volatility. Fourth, there was a dramatic jump in the benchmark three-month cross-currency basis swap. This reflects the strong demand for dollar-funding both end the end of this month, which is quarter-end and for some businesses and government’s fiscal year-end, and the turn of the calendar year-end. This might be exacerbated by US corporates repatriating offshore funds.