Here Is Why EUR Support Remains Solid
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Bottom line: Political uncertainties due to Brexit and European bank's recapitalization needs put the EUR under moderate selling pressure. Removing these uncertainties could see the EUR rebounding with commercial EUR buying providing support.
Europe's policy response: Despite the recent increase in asset volatility, Brexit is still regarded as a local event by us. Europe and its weak European banking sector may be affected, but there could still be a policy response preventing weak European balance sheets becoming a global issue at this stage. In summer 2007 too, investors regarded US subprime as a local issue requiring a local policy response. Related adds of central bank liquidity pushed USD sharply lower and commodities received another shot in the arm, helping EM assets and economies to stay strong.
Helping Italy: Italy’s struggling banking sector is center stage. Of course, Italian banks' EUR360bln of nonperforming loans are large relative to the size of the Italian economy and the size of bank balance sheets, but potentially not big enough to cause systematic risks on a global scale(see our bank analyst's write-up). However, there is a political dimension to this problem which has the potential to impact markets globally, coming into force if PM Renzi loses his Senate referendum in October, not only creating a political vacuum should PM Renzi resign, but also increasing the probability that Italy installs an EMU-critical government aiming to take Italy out of the currency union. Italian retail sales – a reflection of Italy’s tense political climate– have dropped to a 31-month low.
Bank rescue may trigger a EUR rally: We see EUR trading within a binary framework. Should investors put the existence of EMU into question – which could happen should Italy bring in a euro skeptic government– then we believe that EUR would sell off hard. Over recent days when Italian bank debt and its share price development dominated news, the break-up risk premium increased,causing EURUSD to trade moderately lower. A precautionary bank capital injection would buy EMU sometime. Consequently, the EMU break-up risk premium would decline and hence EUR would rally.
For EUR to weaken, long-term capital outflows must exceed commercial EUR buying needs generated by EMU's ever-rising current account surplus. Weak balance sheets combined with low nominal bond yields and falling global inflation expectations take currencies within the current account surplus environment higher.EUR has become an anticyclical currency.
We reiterate our call for EUR to trade higher from here unless populism changes the political landscape, putting EMU's existence into doubt. EURGBP has further upside potential from here should our expectations of the UK aiming for an early GBP undershoot and EMU officials trying to support Italy’s PM Renzi as much as possible come to fruition.
*MS maintains a long EUR/GBP from June 24. *
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