The foreign exchange market has certainly given its verdict on the outcome of the Italian election, with the prospect of a hung parliament in Rome triggering a sharp sell-off in the euro.
With the Italian political system in stalemate, it could take weeks for a new government to be formed. Indeed, a re-run of the election cannot be ruled out.
Unsurprisingly, that has sparked memories of last May’s election in Greece, with the need for a re-vote triggering a slide in the euro and raising fears over a break-up of the eurozone.
Many believe the slide in the euro, which has not yet developed into a full-scale rout, has further to run, even given that EURUSD has dropped almost three big figures since Monday afternoon to its lowest level since early January, and EURJPY at one point was nursing six big figures of losses.
The election results even shifted the FX market’s focus away from the UK sovereign downgrade, putting pressure on EURGBP and helping GBPUSD to hold above $1.50.
“The price action does not seem overdone in our view, given the pre-election air of complacency,” says Geoffrey Yu, FX strategist at UBS. “EURUSD could be guided lower still by the performance of Italian bond and equity markets.”
In some ways, the election results show that the last 14 months since the departure of Silvio Berlusconi as Italian prime minister have been a holiday from the usual drama that is Italian politics, and proved to be a wake-up call for the euro.
Simon Smith, chief economist at FxPro, says the difficulty for investors is in knowing to what degree the election results are a fight back against the reform and austerity being imposed on Italy, or just a return to business as usual in Italian politics. There have, after all, been more than 60 elections in Italy since 1945.
“What it does mean is that the single currency is moving from being the currency-war loser, gaining from weakness in other currencies, to once again being caught up in the euro crisis,” says Smith.
“Further elections look likely, along with more volatility in the euro.”
Indeed, the re-emergence of concerns over the eurozone look set to reverse confidence in the single currency, which has picked up since last summer after Mario Draghi, European Central Bank (ECB) president, pledged to do “whatever it takes” to save the euro and introduced the OMT bond-buying scheme to calm fears over eurozone sovereign debt.
The rebound in the euro was subsequently supercharged by a new era of currency wars, during which the single currency’s status as a store of value outweighed worries over the region’s economic fundamentals.
With the era of the risk-on/risk-off (RORO) trade receding, as Draghi seemingly removed the break-up of the eurozone as one of the main threats to the global financial markets, the tendency for currencies to move in unison in reaction to swings in global risk appetite lessened.
After the collapse of Lehman Brothers and the onset of the financial crisis, that RORO trade dominated price action in currency markets. Perceived safe havens such as the dollar, yen and Swiss franc have rallied as global confidence has waned and perceived risky currencies such as the Australian dollar outperformed as risk appetite improved.
However, after Draghi’s intervention last summer, the FX market moved out of this crisis mode, with local currency drivers, such as a country’s monetary policy stance, becoming more important and outweighing global factors.
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That ushered in an era of currency wars, with country’s such as Japan talking down their currencies in an effort to promote growth.
For its part, the euro benefited from this new paradigm, emerging as a loser in the currency wars. The reasoning went that the ECB, which had spent years trying to preserve the very existence of the euro, was hardly going to join in and talk down the value of the single currency, which stands as a symbol of the health of the European Monetary Union.
However, Ulrich Leuchtmann, head of FX strategy at Commerzbank, says the Italian election result hit the market “like a bomb”, plunging it back into crisis mode and triggering classic RORO price action.
Not only did the euro plunge, but perceived haven currencies rallied strongly. The dollar advanced, the yen clawed back a large proportion of the losses it has suffered this year, while the Swiss franc climbed to its highest level since early January.
“Now the market seems to have fallen back into the old RORO pattern,” says Leuchtmann. "As a result, the mechanics which dominated the past few months no longer apply.
“These are old crisis patterns which are working again. They imply: ignore domestic factors.”
The question is whether the abrupt reversal in the currency market will continue, or whether it is just a brief relapse into crisis mode.
Much will depend on the action in the eurozone bond markets and whether the ECB’s promises of unlimited intervention will soothe investor concerns over the Italian political situation.
Currency investors should expect more volatility as the bond markets decide.