What Next For the Euro?

The euro recovered from earlier weakness against the U.S dollar on Monday after Italian Prime Minister Matteo Renzi’s loss in a referendum over constitutional reform was seen by traders as largely expected and recent euro weakness was seen as having run too far.

 The resounding defeat by a margin of 59%-41% was a strong enough signal to provoke Italian Prime Minister Matteo Renzi to resign following yesterday’s Italian constitutional referendum.
“However, it cannot be compared to the British referendum: Italian people have been called to the polls to vote on an internal constitutional matter, and not on Italy’s long-standing EU membership” policymaker François Villeroy de Galhau said on Monday.

Now that Renzi has handed in his resignation, and until he decides whether he’s willing to stay on, President Sergio Mattarella must establish whether the governing Democratic Party is stable enough to support another prime minister.

One week after Matteo Renzi’s resignation the leadership changes.
The Italian foreign minister, Paolo Gentiloni, has been chosen by Italy’s president to replace Matteo Renzi as prime minister, a choice that signals continuity in the centre-left government’s domestic and foreign policies. Gentiloni’s new role will not be official until he chooses his cabinet and secures a vote of confidence in parliament. A vote will probably occur early this week. The goal of the new leadership is clear: “Accompany and, if possible, facilitate the path of the parliamentary forces to get a new electoral rules.”
The biggest and most immediate crisis facing the incoming prime minister is a financial one. On Friday, the European Central Bank rejected a request by Monte dei Paschi, the world’s oldest bank, for more time to arrange a necessary capital infusion by a consortium of private investors. The decision means that the Italian government may have to intervene to save the Siena-based bank, which is facing collapse because it holds billions of euros of non-performing loans on its balance sheet.

Opposition parties denounced Gentiloni’s appointment and neither Five Star Movement nor Lega Nord, an anti-immigrant party led by Matteo Salvini will attend the meeting with the new Prime Minister set for tomorrow at 12am. Matteo Salvini said Gentiloni’s appointment was “incredible,” calling him “the fourth premier not elected by anyone, the poor and useless photocopy of Renzi” — after premiers Mario Monti, Enrico Letta and Renzi himself.

 How are markets responding?

 On Monday, markets believed it more likely that a caretaker government will be put into place before an election in 2018 (providing some form of stability) as opposed to an early election next year, and populist/anti-Euro parties such as the 5-Star Movement gaining power. Markets were also expecting a “No” vote, which is why any gains were short-lived.

EUR/USD dropped around -1.5% to hit $1.05047, its weakest since March 2015, before recovering to $1.07632 up 0.92 percent on the day. Markets have been quick to perk up.

Another remarkable sign of the effects of EUR/USD turnaround is given by the US Dollar Currency Index (DXY). The DXY, which measures the greenback against a basket of six major currencies, slipped on Monday 0.76 percent to 100.15, compared to the closing price in Nov. 17. The index reached an almost 15-year high of 102.05 on Nov. 24.

A strong but unremarkable U.S. jobs report for November on Friday failed to add additional fuel to the dollar rally sparked by Donald Trump’s surprise presidential election victory on Nov. 8.
U.S. confirm payrolls increased by 178,000 jobs last month after increasing by 142,000 in October, the Labor Department said on Friday.

Also, the unemployment rate decreased from the 4.9% of October to 4.6% in November. The index reached a 1-year high. However, Dollar has not been able to continue his rally since it has overshot the rates story, and so there is some scope for it to pull back over the next couple of weeks.

The next relevant thing to watch in the market this week is the Dec. 14 announcement by the Federal Open Market Committee (FOMC). It will be of particular interest, not only for what it says about any change in interest rates, but also for its signals about the path ahead. Usually, differences in interest rates tend to drive movements in the longer-run, therefore we should wait and see where this decision will drive the market.

Lastly, I personally like to asses the market sentiment through an indicator called Speculative Sentiment Index (SSI) designed by DailyFx.com. The general idea behind this index is that it should be used as a contrarian indicator to price action: if most are long, we forecast price losses. If most are short, we forecast price gains. The last report shows that traders continue buying into Euro weakness, in fact “the ratio of long to short positions in the EUR/USD stands at 1.96 as 66% of traders are long. Previous ratio was 1.60; 62% of open positions were long. Long positions are 11.7% higher than before and 14.8% above levels seen last week. Short positions are 8.7% lower than yesterday and 15.9% below levels seen last week.”

Said that, the fact that the majority of traders are long gives signal that the EUR/USD may continue lower. The combination of current sentiment and recent changes gives a further bearish trading bias.

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