London Session: Monti to blame for sovereign flare up and EUR decline…

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By Kathleen Brooks | February 28, 2013 1:15 AM EST

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The markets have been fairly mixed today with a tepid attempt since the London open to recover some of the Italian election losses of the past couple of days. Italian stocks and bonds are higher today although they are still weak compared to the pre-election levels. The confusion and concern caused by the lack of an outright victor at the Italian elections earlier this week weighed on Italy's bond auction earlier today and yields were higher.

Bad timing on Rome's part


Talk about bad timing - a bond auction two days after the close of the polls of one of the most uncertain elections in Italy's history. The government managed to sell the full allocation of bonds it had targeted (EUR6.5 billion), however the yield Rome had to pay was higher. The average yield on the 10-year bond was 4.83%, much higher than the 4.2% it paid at a similar auction in January. 5-year yields were also higher. It makes sense from an investors' point of view: of course you should demand extra yield if the country doesn't even have a government...

Italian debt still comparatively cheap


However, yields are still comparatively low for Italian government debt; for example, they are 150 basis points below where they were back in July 2012. There are a couple of reasons for this: 1, there could still be a lot of domestic demand for these bonds, especially since the second round of LTRO repayment details showed a sharp drop in early repayments. 2, the markets may be taking Draghi's "we will do what it takes to save the euro" at face value and expect the ECB to step into the void in the event of a dramatic sell off in Italian debt.

Why Monti is to blame for all of this


The latest in the Italian political saga suggests that it really is Monti's fault that the centre-left Democratic Party led by Bersani can't group together a centre left-centre right coalition. The market expected Monti to join a Bersani-led coalition, which was touted as the most market-friendly (and most likely) outcome ahead of the polls. However, the surge in support for the Five Star Movement saw voters ditch Monti for Grillo, leaving Monti with only 10% of the vote, compared to Grillo's 25%, and without the clout needed to patch together a coalition.

So there you have it - Monti is to blame, or to be more precise what is to blame for this period of political upheaval is Monti's Germanic-style austerity drive over the last year or so which has repulsed voters. Although the majority of Italians wanted to stay in the euro (in a poll taken before the elections), the sharp increase of support for the Five Star Movement was an outright rejection of the current political status quo. This uncertainty should be euro negative in the medium-term until a new government is formed and its policy direction is known.

However, if Bersani can form a government in the coming days, albeit an extremely fragile one, then the euro could stage a relief rally. One thing the Eurozone and the markets don't like is a change to the status quo, especially one that includes ditching the German-led path to austerity. As I have said before, this is a laudable goal, but the strategy to implement it has been woeful, as the world is finding out via the Italian elections. Thus, things may be calm now but they may not stay that way for long.

UK growth improved for the year, but dipped towards the end


Elsewhere, the UK's annual growth rate for 2012 was revised up from 0% to 0.3%, however the data for Q4 was fairly dismal with further declines for gross fixed investment and imports and exports. Exports continue to decline at a faster pace than imports, further putting the UK's great economic rebalancing further off course. Adding to the dismal news, employee wages only rose 0.1% over the quarter, although pay rises don't usually come into effect until the start of the year. GBP didn't let the bad Q4 news get in the way of a nice recovery, and it continues to test 1.5150 short term resistance. Right now 1.5075 - 1.5220 looks like the temporary range this cross is trading in for now. Next week's BOE meeting and start of the month PMI data will be the key drivers of sterling in the coming weeks, so we could range trade for the next couple of days.

Ahead today US durable goods orders (1330 GMT) and Bernanke's second day of testimony on Capitol Hill (1500 GMT) will be in focus, as will any potential news on the sequester from Washington.

One to watch:

In the FX space today the euro is recovering in line with the rest of European assets, after 1.3030 - base of daily Ichimoku cloud and 200-day sma - held as good support. This is now a temporary low for this cross. We think it will eventually be breached, and the calm in the markets now could be disrupted yet again by Italian power fears. Thus, we think this cross is a sell on any rallies back towards 1.3150.

We are also watching AUDUSD closely. It has taken a pounding this week and is close to the 1.0150 support zone. There are two outcomes for this cross, we believe: 1, more risk aversion - we would expect AUDUSD to fall back through 1.0150 support, potentially declining to 0.9700 lows from June 2012, 2, things start to calm in the markets and 1.0150 acts as a buying zone. Right now the daily momentum indicators point to some further downside, although in the medium-term this cross is starting to look oversold. With the Italian political situation as it is, we really think that the markets could go either way, so traders of the Aussie need to be nimble and ready to act immediately as we approach this key level.


Best Regards,

Kathleen Brooks| Research Director UK EMEA |

d: +44.(0).20.7429.7924 | f: +44.(0).20.7929.2010 | M: +44 (0) 7919.411.957 | e:| w:

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