Tomorrow there is a new stage in the Italian state budget procedure. The Italy is expected to provide a revised budget on November 13, and the European Commission (EC) will give a feedback on draft budgets for 2019 on November 21. In case if two sides do not find some common ground the Excessive Deficit Procedure might be opened. If that occurs Italy will be given couple of months to correct the budget before EC applies sanctions. Therefore tomorrow will show if the Italian budget issue will last for a longtime or it will be resolved with no additional distress in the market. Currently Italy has around 131.2% debt-to-GDP ratio with 131.8% being peak in 2014. It is true that the ratio is decreasing for the last years, however the pace is extremely slow if we compare to the increase from around 116% to 131.8% during 2011-2014. Couple of weeks ago Moody’s downgraded the sovereign rating of Italy while keeping the outlook “stable”, and the S&P kept the rating unchanged while lowered the outlook from “stable” to “negative”. These changes did not affected short-term yield spread over Germany, whereas long-term spread jumped to 3.03%, with the peak during the Italian elections being 2.88%. I think the long-term spread can widen to 3.5% if Rome and Brussels do not compromise on budget.
More negative news for Italy comes from the ECB monetary policy side. There are two components: 1) TLTRO 2) interest rates. Deposits with the ECB held by the second largest Italian bank (40 bn) accounts for almost half of the total deposits held by the Italian banks, and the total financing of the Italian banks through the TLTRO accounts for 239 bn (60.5 bn are TLTRO drawings of the second largest bank). As a result smaller banks might be under bigger pressure than the larger ones when the payments due date comes. Second impact is already known one and is linked to the expectation that the ECB will exit easing this year and might increase rates during second half of the next year. The vote on the end of the asset purchases by the ECB is expected to be announced on December 13. Not to mention German Council of Economic Experts cut their GDP growth forecast for Germany to 1.6% from 2.3% for 2018 and to 1.5% to 1.8% for 2019.
Regarding the EUR swap 2-10 year spread I expect steepening in the near future as I expect the growth trend of the Eurozone to be reversed and flattening afterwards due to the shift in the monetary policy of the ECB. Currently the spread is 1.07%, which is slightly below this year average (1.11%). I checked the same for the US, and there is a different picture. The spread is at 0.13% with lowest for this year being 0.085%, there is not much downside potential. I believe 75% of the December rate hike is already priced in short-term yields. The recent volatility in yields was triggered by the midterm elections in the US. Republicans lost the majority in the House of Representatives, and this fact may prevent further expansionary fiscal stimulus and reduce the US budget deficit. This in turn can place a cap on long-term treasury yields. On the other hand Republicans achieved increased number of representatives in the Senate. Trump might be satisfied with the result accenting he has succeeded with the policy he is dictating. Most stock indices lost biggest portion of the year-to-date gain during October, with possible negative result for the Republicans, the S&P index in particular fell as low as 2650 from 2930. The correction took place only during the end of October and beginning of November. Abating trade conflict might trigger risk-on sentiment, as the House announced there was a telephone call between Trump an Xi. Therefore in that sense the G20 meeting at the end of November should be closely watched. China’s liberalization can create favorable negotiating climate during the above-mentioned meeting.
EUR/USD weekly pivots are 1.1568 and 1.1384 on the resistance side and 1.1268 and 1.12 on the support side, for the GBP/USD the levels are 1.3251 and 1.3112 on the resistance side and 1.2896 and 1.2819 on the support side. If we take a look at implied volatilities and risk reversal the following can be observed. Implied volatility of the GBP/USD has peaked at a level of around 11, which is highest for this year. Looks like there is a rising demand for the options in the market and the risk reversals indicate the market favors the put side, thus the market is bearish for the GBP/USD for this year. The implied volatility for the EUR/USD is close to the year-to-date average with the risk reversals indicating the same as for the GBP/USD. Based on my technical analysis of the spot market I do not expect the EUR/USD to move sharply below 1.12 before there is a 100-150 bps correction. However applying the same analysis for the GBP/USD I believe there is still some room for further depreciation and some pressure on the pair will come from the EUR/GBP trades. According to the CFTC data number of future contracts for both GBP/USD and EUR/USD moved deeper into negative territory indicating further depreciation of both pairs.