Focus is now on Italy - Nomura

Analysts at Nomura explained that focus is now turning towards Sunday’s referendum in Italy.

Key Quotes:

" FX and rates markets look to be pricing in a high possibility of a “No” result, so it may not be a major driver of further EUR weakness. But this is just a stepping stone and the Italian political situation could be an important market theme beyond the referendum."

"In fact, EUR trading behaviour against political risks has been changing recently and there is a growing risk of negative reactions in EUR becoming more significant. We also published a guide to Trading the Italian referendum. In addition, we have the ECB meeting next week, where our economists expect a 6m extension to the QE programme. This should accelerate foreign bond outflows further, which would be EUR negative."

"Even if the ECB were to turn more hawkish, weaker foreign bond investment by euro area investors could hurt risk sentiment globally, if the negative impact of political risk spills over to the foreign bond markets, which could be EUR-negative. Looking at historical episodes of increases in US yields driven by shifts in US inflation expectations, we see that in the past, such rises have been accompanied by smaller moves in the dollar."

"Yet when real yields rose with falling inflation expectations, the dollar rallied by over 3%. So for the dollar to continue to rally, we would really need to see inflation expectations fall with rising yields. The Fed’s ability to bring inflation expectations down will therefore be important in coming months.

We have also looked at what consensus got right (and wrong) in 2016, and what it expects for 2017. The biggest errors, in our view, were on the US economy and the Fed, but also underestimating the importance of politics. Next year, consensus once again looks for a stronger economy and more aggressive Fed hiking cycle."