Forex: Yen Gains, Euro Sinks on Political Jitters in the US and Italy

Talking Points

Yen Rallies on Haven Demand as US, Italian Politics Drive Risk Aversion
Soft CPI Data May Set Dovish Tone for ECB Bets, Compound Euro Selling
Dollar Unclear About the Ups and Downs of a US Government Shutdown

The Japanese Yen outperformed to start the trading week as risk aversion struck financial markets, sending Asian stock exchanges lower and driving demand for the safe-haven currency. The MSCI Asia Pacific regional benchmark equity index plunged over 1 percent, with political jitters in the US and Italy unnerving investors. European and US stock index futures are trading sharply lower, arguing for continued blood-letting through the rest of the day.

In the US, worries about a looming government shutdown are reaching fever pitch after the Republican-controlled House of Representatives passed a measure that linked funding through mid-December to a delay on implementing the Affordable Care Act, commonly referred to as “Obamacare”. That trade-off is likely to be rejected in the Democrat-controlled Senate, meaning that passing a budget by the October 1 deadline looks unlikely.

Presumably, the markets view a possible shutdown in terms of its negative implications for market stability and the negative global growth implications of sudden fiscal retrenchment in the world’s largest economy. What this means for the US Dollar US Dollar is unclear however. On one hand, similar instances in the past (most notably, when Standard and Poor’s stripped the US’ AAA credit rating in 2011) saw the greenback rally on haven demand. On the other, the negative implications of a shutdown on US growth may mean the Fed will maintain QE as-is longer than expected, a negative driver for the reserve currency.

Meanwhile in Italy, embattled former Prime Minister Silvio Berlusconi attempted to shatter the ruling coalition over the weekend when he ordered cabinet ministers belonging to his PdL party to resign. That would create a power vacuum in the largest of those Eurozone countries that have been at the front line of the region’s debt crisis of recent years, with potentially dire consequences. Indeed, the Euro yielded the worst performance among the G10 FX majors in Asia.

More of the same appears likely ahead. The Germany-Italy 10-year bond yield spread has jumped to a two-month high, hinting the single currency remains vulnerable amid swelling funding stress. On the data front, the flash estimate of September’s Eurozone CPI reading is expected to put the headline year-on-year inflation rate at 1.2 percent, the lowest in five months. That may drive expectations of a dovish turn at this week’s ECB meeting, compounding Euro selling pressure.

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