Week Ahead: 24th September 2018

This is a busy week for financial markets, with plenty that could drive asset prices. Below, we look at three key events to watch for this week.

1, The Italian Budget

After months of discussions and market nervousness, the deadline for the fragile Italian coalition government to deliver its inaugural budget is Thursday 27th September. Earlier last week Italian bonds rallied, and bond yields fell, as Prime Minister Conte said that the government needed to present a plan within EU budgetary rules that would not spook investors. However, not all coalition members want to play by the EU’s rules, with the deputy PM Di Mayo, from the radical Five Star Movement, threatening to pull the plug on the country’s populist government if it cannot find money to implement election campaign promises.

Herein lies the problem with Italy’s Budget. As a member of the euro its budget deficit should not exceed 3% of GDP, which is the equivalent of EUR 56bn in spending, however the government’s various election spending promises amount to EUR 98bn, which would take the deficit well above the EU’s limits. Italian bond yields rose at the end of last week, and they are at risk of breaching the key 3% level if further divisions within the coalition arise before the 27th.

The biggest risk for investors is that the Italian government falls apart. A government break up would put the budgetary timetable into disarray and would likely put significantly more upward pressure on Italian bond yields. This may have also an impact on the euro, with EUR/USD at risk from a sell off. The euro rallied sharply last week, and some investors were looking for a move back to 1.20. However, it is hard to see this happening with Italian budget risk rising, and the risks are increasing that a sell off could occur.

In our view, there are two outcomes to this Budget. 1, Prime Minister Conte bows to pressure from the Five Star Movement and allows a spending splurge that ignores EU rules. This could lead to a clash between Rome and Berlin, with political strife likely to weigh on the euro in the short term. However, a far worse outcome for the euro would be a break up of the government. This would make another election likely, and a bigger win for the radical Five Star Movement and potentially for anti- EU parties to make political gains. If there is a chance that Italy could be next in line to have a referendum on EU membership on the back of this Budget, then the downside for the euro could be long-lasting.

2, UK’s economy in focus

The final reading of UK GDP is scheduled at the end of this week. The market expects no change, and for Q2 GDP to be confirmed at 1.3%, on an annual basis.  This GDP report comes on the back of a run of strong economic data for the UK, with the Citi Economic Surprise Index for the UK at its highest level since end of January. This has helped to drive sterling higher, and GBP/USD surged to its highest level since July last week. The UK/ EU summit managed to pass without too much impact on the pound. Although nothing concrete was confirmed, the fact that both sides appear to be working towards a deal in time for the Brexit deadline of next March, was deemed encouraging. If Brexit negotiations continue in this vein, then the 1.2662 low from 15th August could be the nadir for GBP/USD in the medium-term. However, we would note that any deterioration in the Brexit negotiations over the weekend could trigger another sell off, and $1.33 in GBP/USD is a major level of resistance that could trigger some profit-taking as it is the 38.2% retracement of the entire April to August decline.

3, FOMC rate hike expected

The market is confident that the FOMC will hike interest rates this week, with a 25-basis point rise to 2%- 2.25% expected with a 98% probability, according to the Fed Funds Futures market. The actual rate hike will not be the interesting part of this FOMC meeting, instead the latest Dot Plot from the FOMC will be watched closely. The Dot Plot gives the distribution of views about where FOMC members believe that Fed rates will move in the future. The latest Dot Plot expects rates to rise a further 3 times in 2019, however, will the recent deterioration in the data, especially the August CPI miss, be enough to shift the FOMC to a more dovish path in 2019?

As we lead up to the FOMC meeting the dollar has been in decline, the dollar index dropped below its 100-day soma last week and was potentially on track to test the 38.2% retracement of the Feb to August uptrend at 93.65, a key support level. Interestingly, the 10-year Treasury yield made large gains last week and broke above 3% to its highest level since May. Whether the dollar will catch up with Treasury yields, or if Treasury yields fall back in line with recent dollar moves, could be dependent on the outcome of the FOMC meeting this Wednesday 26th September from 1900 BST.