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To see where markets will feel the most strain from this week’s EU elections, watch one country fighting the bloc and another trying to leave it.
Italy’s ruling populists have already threatened to violate European Union budget rules and a strong performance could spur a blow-out in bond yields and greater volatility. Gains for their ideological peers across the continent might also hurt the pound and the euro by increasing the chances of a hard Brexit in the U.K. and making it more difficult for proponents of closer European ties.
The risks for Italian investors are two-fold in the wake of the parliamentary vote from May 23-26. Matteo Salvini’s League party is expected to boost the number of seats it holds to 27 from six currently. Such a result could embolden a hardline stance on the nation’s deficit, or collapse the ruling coalition.
“I expect a significant protest vote,” said James Athey, a money manager at Aberdeen Standard Investments. “If the League bring home the result they’re hoping for and polls are mostly suggesting, and we get similar results elsewhere, it makes for a very interesting state of affairs with regard to fiscal rules. Obviously, in Italy, I am short.”
The current coalition with the Five Star Movement party could come under further strain, leading to volatility in the short-term, though many investors may welcome a new government with less of an emphasis on boosting spending. JPMorgan Chase & Co.’s base case is the government collapsing in the summer, with the Italy-Germany 10-year yield spread narrowing to 200 basis points by March 2020, from 278 basis points currently.
Goldman Sachs Group Inc. is betting that the coalition is likely to stay together and could continue to push back on the EU’s fiscal constraints. Its short-term target for the 10-year yield spread is 330 basis points, a level not seen since the height of the budget battle last year, but still short of the 574 basis-point peak during the euro-area debt crisis. Italian bank stocks could also be hurt by the prospect of a more expansionary fiscal policy, according to Michael Hessel, an economist at Absolute Strategy Research.
“Salvini’s probable emergence as the new European strongman is most relevant as it argues for another budget clash with the European Commission after both parties have already sharpened their rhetoric,” said Michael Leister, head of rates strategy at Commerzbank AG. “This implies persistent widening pressure on Italian bonds, with investors using relief phases to offload risk rather than treating dips as buying opportunities.”
The U.K. was supposed to have left the EU already, but instead domestic parliamentary stalemate has meant the country is set to contest the elections Thursday. The Brexit Party founded by the anti-EU Nigel Farage is expected to top the vote, while Prime Minister Theresa May’s ruling Conservative Party is set to be routed, according to recent polls.
A large win for the Brexit Party could further ramp up the pressure on May to resign, which could in turn cause sterling to fall 2% against the dollar on the day, according to Nomura International Plc. It could also increase the chances of a hardline Brexiteer replacing May. The pound has already dropped more than 3% in its longest losing streak ever against the euro in the past 12 days.
“If the Brexit Party makes further strides and increases its share of the vote above what UKIP gained in 2014, this would not bode well for the state of U.K. politics and no-deal Brexit concerns,” said Jordan Rochester, a currency strategist at Nomura.
Europe’s common currency is currently languishing near a two-year low against the dollar, with rising populism on the continent adding to weakening sentiment over the region’s tepid inflation and stalling economic growth. Despite the recent rhetoric from Italy, few populists are campaigning for an EU exit and are instead pushing for policies such as the restoration of internal borders and cutting migration.
In total, populist parties are seen getting around 180 spots in the EU’s 751-seat parliament, short of a majority. For UBS Group AG, any sign that European populism may have peaked could cause the euro to rally, particularly against haven currencies such as the Swiss franc. Others though are less convinced. Aberdeen and JPMorgan are both short the euro against a basket including the dollar and yen.
“A narrower coalition could emerge among right-wing populists that could, if it were to advance the cause of greater national independence, potentially remind investors of the latent risk that the single currency could one day break apart,” Paul Meggyesi, head of foreign-exchange strategy at JPMorgan, wrote in a note to clients.
Traders’ focus on Italy might be blinding them to the ramifications for the bloc’s biggest economy: Germany. Chancellor Angela Merkel is feeling the pressure from her chosen successor, Annegret Kramp-Karrenbauer, to quit following the EU vote, according to two people with knowledge of the situation. That could add to risk-off sentiment that has already driven German bund yields to the lowest level since 2016 this month, according to Arne Lohmann Rasmussen, head of fixed-income research at Danske Bank A/S.
The outcome of the vote could have an impact on who becomes the next head of the European Commission and also the European Central Bank. If the next Commission president isn’t German, that could boost the chances of the ECB post going to Bundesbank President Jens Weidmann, seen as one of the more hawkish policy makers.
With traders in money markets currently pricing a 50% chance of the ECB cutting interest rates by the first quarter of 2020, any signal of a change in policy stance by Mario Draghi’s successor would ripple through the region’s bonds.
“Every way you look, we are heading to a period where the euro zone needs to face up to the realities and challenges,” Aberdeen’s Athey said.
(Adds Italy-Germany yield spread record in sixth paragraph.)
--With assistance from Charlotte Ryan and Justina Lee.
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