Late last night the Italian government passed plans to run its budget with a deficit of 2.4 percent of its GDP.
European markets were so rattled the pound-to-euro exchange rate peaked at 1.1252 – levels last seen a week ago.
And while the decision may bring temporary relief, analysts are predicting further trouble ahead, with analysts alarmed at the prospect of increased public spending which some estimates suggest could total €20 billion over the course of the next three years.
Without a breakthrough, Sterling is vulnerable in the near-term, but recent price action indicates that investors may be less pessimistic about a ‘no deal’
Meanwhile analysts at ANZ suggested optimism about Brexit may also be boosting the value of the pound, despite concerns about the UK leaving the bloc without a withdrawal agreement in place.
Head of global economics Brian Martin said: “Without a breakthrough, Sterling is vulnerable in the near-term, but recent price action indicates that investors may be less pessimistic about a ‘no deal’.”
However, not everybody agrees – Adrian Paul, a foreign exchange strategist with Goldman Sachs, said: “If it were to happen, our FX strategists argue that a combination of heightened uncertainty and prospective adjustment could precipitate a 10 percent nominal Sterling depreciation in the first six months.”
Italy’s debt is already the second highest in the eurozone as a share of economic output after Greece, at about 131 percent of GDP.
Italian finance minister Giovanni Tria, who had wanted a figure closer to 1.6 percent, found himself overruled by coalition partners Matteo Salvini, of Lega, and Luigi Di Maio, of the Five Star Movement (5SM).
The pound is buoyant against the Euro
Mr Tria remains in his job despite concerns he might resign after the humiliating climbdown.
The immediate concern was over fears the Italian Government might ratify a budget deficit target about the three percent cap imposed by the EU’s Stability and Growth Pact, and to this extent the news came as a relief to markets.
However, Lee Hardman, currency analyst with MUFG, suggested Mr Tria had given in to pressure “from the populist parties” to incorporate more stimulus to support growth.
The outcome still represents a material widening of the deficit compared to an expected deficit for this year of around 1.6 percent of GDP.
He added: “The higher than expected deficit increases the likelihood that European officials will express dissatisfaction, although they will have to be wary of playing into the populist government’s agenda.
predicted a vigorous pickup in euro zone inflation
“Overall, it leaves the euro more vulnerable to the downside in the near-term although we are not convinced that any weakness will be sustained.”
The euro on Friday fell 0.2 percent to $1.1615 after slumping almost 0.9 percent overnight. Versus the Swiss franc it traded at 1.1347, near a one month low of 1.1415.
Ulrich Leuchtmann, FX strategist at Commerzbank in Frankfurt, said: “It does come as a surprise that the euro exchange rates suddenly react in such a pronounced manner to fiscal factors.
“But market participants are now hoping for a normalisation of ECB interest rates.”
ING currency strategist Viraj Patel said the Italian budget debate remains a “headwind, rather than an active drag, on the single currency.”
Luigi Di Maio and Matteo Salvini overruled economic minister Giuseppe Tria
European Central Bank chief Mario Draghi this week predicted a vigorous pickup in euro zone inflation.
Barclays said pound sterling could receive a small boost during the final quater of this year that will see it end 2018 higher against the euro and US dollar.
According to the banking giant, the British currency is likely to experience a “small bump” once a Brexit agreement with Brussels is agreed.
The pound is currenctly trading at 1.3062 against the dollar and is expected to rise to 1.32 by the end of the year.
Against the euro, the pound is expected to rise from 1.1243 to 1.1496.
Analysts also believe the Article 50 deadline might be extended to enable both sides to reach a compromise.
Nikolaos Sgouropoulos, an FX analyst at Barclays, told www.poundsterlinglive.com: “Although we are under no illusion that the divide between parties on a deal is anything less than vast, the ambiguity around the eventual form of an exit under Article 50 is also large, leading us to be confident that an exit with a transition agreement will be achieved.
“We now expect a small bump in GBP following an agreement on exit, but for it to be unwound once disappointment over the path of the BoE materialises.”
But despite the short-term forecasted revival of the pound, Barclays is not overly optimistic on its progress for 2019.
If the Bank of England was to raise interest rates, it would drive currency appreciation through atrracting more foreign deposits due to the higher rates on offer.
All eyes will be on the Bank of England over its next move on interest rates
But the central bank would not be able to impose a hike because of slower-than-expected growth.
It could then side with a ‘withdrawn’ approach, with Barclays forecasting the pound to go on the reverse in 2019, falling to 1.31 against the US dollar in quarters 1-2 before recovering slightly to 1.32 in Q3.
Barclays has also forecast the pound will fall to 0.88 versus the euro, with the exchange rate coming in at 1.1363.
Commenting on the path for Bank of England interest rates, Mr Sgouropoulos said: “Our reading of the economy is that it continues to slow and is unlikely to support further rate hikes.”
For more details visit www.poundsterlinglive.com