Investors head for shelter amid Italy's budget woes

European equities suffered a blow over fears the country's budget plans could lead to a higher deficit

Matteo Salvini, Italy's deputy prime minister, speaks during a news conference with Marine Le Pen, leader of the French nationalist National Rally party, not pictured, at the "Economic Growth And Social Prospects In A Europe Of Nations" event in Rome, Italy, on Monday, Oct. 8, 2018. Salvini said Europe's real enemy is Jean-Claude Juncker and the Brussels bureaucracy that pushes budget restrictions and open borders. Photographer: Alessia Pierdomenico/Bloomberg
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The markets kicked off October by adopting a risk off approach. European equities have been selling off and the euro was trading lower following developments in Italy’s highly controversial budget plans.

The plans will see the country’s deficit grow to 2.4 per cent of GDP – a figure within the European Union’s mandate but well higher than the 0.8 per cent committed by the previous government.

The laxity towards the EU’s budget rules has raised concerns that Italy would run a larger budget deficit over the next three years and the recent war of words suggests that the populist government is not backing down. This week the Italian Interior Minister, Matteo Salvini, in a speech alongside French far right leader Marie Le Pen, accused the European commission president and the economics commissioner of being enemies of Europe.

The developments weighed heavily on European assets: Italian bond yields were at four-year highs; the Euro Stoxx 50 index dropped 2.5 per cent on the month and the Euro sold off to below 1.15 levels against the US dollar, its lowest in seven weeks.

This performance is in sharp contrast to last month – with the EUR/USD surging to nine-week highs on the back of optimism garnered from the September European Central Bank announcement. We noted then that the move would fade at 1.19 before a larger selloff, which would expose 1.11 levels.

Keep an eye out for further signs of defiance from Rome in the lead up to their submission of the draft budget to the EU commission due on October 15. This tension will keep the euro jumpy as we get more comments from Italy, Europe and the ECB. Over the next 10 days I would not expect to see the pair breach 1.1730 levels on the upside with a move towards 1.13 more likely, however with the nature of such proceedings, it would prove prudent to employ tight stop losses through the course of the next two weeks.

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As expected, the greenback moved higher through the start of October – hitting 95.80 levels in trading last week, just shy of our 96-target given in September. The Federal Reserve raised US rates by 25 basis points to the current 2.0-2.25 per cent band, where it was last in April 2008. Along with the hike, the Federal Open Market Committee committed to one more rate hike in 2019 and were more hawkish in their comments – most notably dropping language that “the stance of monetary policy remains accommodative". There was further optimism for future US economic prospects with the FOMC upgrading the GDP projections for 2018 to 3.1 per cent, up from a 2.8 per cent projection back in June.

With the FOMC at the forefront of the rate rise cycle, the dollar has remained in demand. The US dollar has also come in for buying support as a result of the on-going US-China trade wars. While there have not been any large developments, as China has been off for a week-long holiday, the Chinese yuan tumbled to a seven-week low after the People’s Bank of China said earlier this week it was cutting the reserve ratio requirement by 100 basis points, which would see more than $100 billion being injected into the banking system.

This is the fourth such move by the PBOC which suggests they may be poising for additional, unfavourable developments in the trade war theme.

Amidst this, the Dollar Index is primed to continue consolidating in the current channel between 94.30 and 96.00.

US inflation figures are due out on Thursday, which could see some volatility come in if there’s a missed print. Core CPI is expected to grow to 2.3 per cent year-on-year and 0.2 per cent month-on-month.

Meanwhile, the British pound has had a mixed start to the month. We noted initial support coming in GBP/USD at 1.30 levels and the pair traded as low as 1.29 last week before re-tracing back above that key 1.30 handle. The short-term fortunes of the pound are tied to the likelihood of prime minister Theresa May negotiating a favourable Brexit in the lead up to EU Summit, set to take place on October 17 and 18. The summit is seen as a potential opportunity for a final agreement on Brexit terms with the EU - however all eyes will be on Mrs May and if she can get the terms she seeks before the Summit rolls around. Expect punchy pound moves through the two weeks ahead, with lows of 1.27 and highs of 1.33 in range.

Finally, gold remains locked in this current range with buying coming in at 1180 with upside moves capped at 1220. The Indian rupee continued weakening with the USD/INR currently trading at new historic highs at 74.00 levels. Emerging markets have eroded across the board – and with the rupee sinking to record lows against the dollar it would prove prudent to see the depth of this current selloff before building a longer term position in the pair.

Gaurav Kashyap is a market strategist at Equiti Global Markets

The views and opinions expressed in this article are those of the author and do not reflect the views of Equiti