Fundamental Forecast for EUR/USD: Neutral
– Bank of Italy Quarterly Economic Bulletin on Friday of keen interest.
– Italian government likely to move to
- FX market volatility is rising ahead of the UK-EU referendum – it’s a good time to review risk management principles.
The first full week of July was a middling one for the Euro, with no clear differentiation in performance among the typical high yielding-low yielding/risk-funding currency fault lines. Case and point: the British Pound and the Swiss Franc were the worst performers; while the Japanese Yen and the New Zealand Dollar were the best. Instead, markets still remain highly attuned to developments out of Europe, specifically the UK, as the political and economic fallout from the June 23 referendum continues to take shape.
In this new Europe-centric environment, one victim from the Brexit collateral damage has already revealed itself: the European financial sector. Now down over -25% year-to-date, EUFN, the MSCI Europe Financial Sector ETF, has fallen by approximately -19% since the Brexit vote. Yes, the financial sector is Europe’s sick man du jour. But which country is the financial sector’s sick man? Look no further than Italy.
According to data compiled to the Wall Street Journal last Monday, July 4, 19% of loans on Italian banks’ books are bad, amounting to €360 billion. For context, at current exchange rates (roughly €398 billion), that means Italian banks have nearly three times as many bad loans as US banks did when the global financial crisis reared its head. This is a major cause for concern. The Bank of Italy’s Quarterly Economic Bulletin on July 15 should shed additional light onto the festering situation.
Given the country’s lackluster pace of growth and ongoing slide in Italian banks’ equity, there are two possible outcomes: a collapse of the Italian banking system, which would have tremendous consequences as the Euro-Zone’s third-largest economy; or more likely, a bank bailout is on the way. Bad loans – nonperforming loans – clog up banks’ balance sheets, rending them unable to use the capital in more productive manners.
