Will Italy Provoke Another Euro Zone Crisis?

Most of the trading session, the EUR/USD was being propped up by buyers defending the October 9 bottom at 1.1432. They even came in yesterday at 1.1433 to stop the price slide. However, due to the events on Tuesday, it looks as if these levels are ready to blow with the daily chart showing plenty of room to the downside with the August 15 main bottom the next target at 1.1301. How and when it gets there will be the next two questions.

Just a short while ago, the European Union rejected Italy’s budge plan for 2019, emphasizing the Italian government must revise its current proposal.

The lingering dispute over Italy’s budget has brought the likelihood of further political turmoil in Europe to the forefront at a time when its seemed like the entire investment community was focusing on the Fed, rapidly rising Treasury yields, the Middle East and the trade dispute between the U.S. and China.

The stalemate between the EU and Italy comes at a time when investors are nervous and when fear takes over, investors take profits and sell, hoping to wait out the worst until the situations stabilize.

It is at times like this that a voice of reason tends to speak up to calm investors, but since these events are spread all over the world, there is no single voice of reason. The EU is battling the Italian government. The U.S. is battling China. Saudi Arabia is in conflict with Western leadership and President Trump is at odds with the Fed. There is a tremendous lack of trust in the global economy and conditions could turn uglier as a result.

Traders are saying that the situation in Italy has reached a point where it is now threatening the European Central Bank’s plan to raise interest rates next summer as previously planned. The inability to raise rates at a time when the hawkish Fed is talking about one more rate hike in December and possibly three more next year could put huge selling pressure on the Euro.

We’ve seen the chart which ominously points toward 1.1301, now we know the reason. Everything always seems to drift back toward interest rates.

There have been whispers for months about the possibility of Italy leaving the Euro Zone so I’m not participating in rumor or gossip. Investors have been quietly saying for months that the budget crisis in Italy has the potential of being bigger than Brexit.

Ask a Brit and they’ll tell you that Europe revolves around the U.K., but the ongoing Brexit negotiations seem to be dispelling this myth. However, Italy leaving the Euro Zone could actually be the first step in dismantling the Euro.

Italian banks are flush in Italian government debt so they don’t want to see Italy leave the Euro Zone because everything they own will be devalued, which means they face the threat of default. The banks seem to keep feeding the government to spend more by lending them money. So the banks and the government apparently are joined at the hip.

The Italian government wants to borrow more than European Union guidelines allow and this is the issue. Italy wants the EU to stay out of their business. If the stalemate continues then the European Central Bank may have to step in and start buying Italian debt. This would help the government and the banks, but it’s not what the ECB wants to do because it is exiting the debt-buying business. To go back on its word to trim debt purchases and move toward raising rates would cause serious consequences in the Euro Zone economy.

The bottom-line is Italy is too big to fail, but nearly impossible to save at this time if continues with its ways. It’s the Euro Zone’s third largest economy and its debt reaches a vast number of Euro Zone countries as well as international banks.

I don’t think we’ve reached the point of Italy leaving the Euro Zone, but we are starting to see the fear of contagion set in with global equity markets plunging on today’s news. Investors are saying where there’s smoke, there’s fire. They would rather sell first and ask questions later. That’s where we are at right now, but it’s not going to take much more to escalate concerns.