Italian Referendum and a case for parity in EUR/USD

Italian referendum is no Brexit saga, but could eventually lead to ‘Italeave’ or ‘Italexit’

European leaders will be glued to their screens this Sunday as Italy heads to referendum. Retail crowd does not really understand what the referendum is all about. For them, things are pretty straight forward – A ‘no vote’ victory would be bad for EUR and Eurozone and vice versa.

However, things are not as straightforward as they appear.

What is the referendum all about?

Italian PM Matteo Renzi has been lobbying aggressively for a package of reforms that would drastically shrink the size and power of one of Italy’s two houses of parliament. These reforms are expected to end corruption, red tape and delay in government work.

So a ‘Yes’ victory in the referendum would be good, right… That is a common sense. The real issue is if the ‘No’ vote wins i.e. if the voters reject the reforms, Renzi would resign and that would open the doors for the Five Star Movement, an insurgent populist party led by a former comedian who wants Italy to abandon the Euro.

So as you can see, a ‘No vote’ victory could end up in ‘Italeave’ or ‘Italexit’.

Now the question arises is – if the reforms are expected to put an end to corruption, red tape and delay, why would Italians reject it.

The simple reason is that a ‘no vote’ victory would open doors for anti-EU Five Star movement. There is wave of anti establishment across the globe. Trump victory is probably a biggest evidence of the anti establishment wave.

Now that we know the purpose of the referendum, let us look at the possible impact on the EUR/USD pair.

We have two scenarios – no vote victory or yes vote victory.

No vote victory has been priced-in…but the contagion is yet to be priced-in

This may come as a surprise, but yes, a ‘No vote’ victory has been priced-in. In the previous two mega events – Brexit and US elections – both Brexit and Trump were distant dreams and were not priced-in at all. Furthermore, Pundits were totally wrong about the market reaction on Brexit and Trump victory.

This time the market is prepared for a ‘no vote’ victory. Take a look at the German 2-year yield, it is trading -0.738%, i.e. at least 33 basis points lower than the ECB deposit rate of -0.30%. The recent low stands at -0.769%.

Note, that the 2-year yield has declined at a time when the global bond yields are on rampage… led by the Trump Bump and the treasury yields. This clearly states that a ‘no vote’ victory has been priced-in.

However, what’s not priced-in is an eventual threat of ‘Italeave’/’Italexit’. Moreover, a no vote victory in Italy would also force markets to begin pricing-in the rise and eventual victory of anti-EU parties in Germany and France in the 2017 elections.

To cut the long story short, EUR/USD may see a minor spike to 1.0850 on ‘sell the rumor, buy the fact’ trade, but eventually would begin its journey to parity.

Yes vote victory would be a surprise

‘Yes vote’ win will be a surprise and that could boost the EUR/USD to 1.10 and may be to 1.12 in the short-run. However, the overall trend still remains bearish and the currency is more likely to head towards parity than not on account of the widening yield differential (higher US rates). Only, a serious risk-off triggered by a major sell-off in the US stocks would help the EUR/USD get back to 1.15 levels.

Technical Charts scream sell-off to parity!

Monthly chart

eurusdmonthly

Source: Netstation (www.netdania.com)

  • The rising trend line support is seen around just above parity. Also note the 61.8% Fib level stands at 1.01158.

Monthly chart – Zoom-In on 2008-2016 – Bearish flag

eurusdm.jpg

Source: Netstation (www.netdania.com)

  • We see falling tops formation, followed by a sharp, almost 90 degree sell-off since mid 2014 to March 2015.
  • From March 2015, the pair has been restricted to a sideways trading range.
  • To cut the long story short, we have a bearish flag, which, if breached would open doors for a sell-off to 0.95-0.96 levels!
  • Given the falling top formation and the macro-political picture, it is safer to say that the odds of a bearish break from the bearish flag formation are high.
  • Only a monthly close on the higher side would signal bearish invalidation and shall put the parity calls to rest.
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