Bank of America Merrill Lynch discusses the EUR outlook in light of Italy's budget developments, and thinks that in the short-term, Italy is likely to keep driving the EUR lower.
"The Italian government is effectively "picking a fight" with the EU, in our view. Some EU governments violated fiscal rules in the past, but did not do this so blatantly. This is the first time a government is clearly ignoring the rules and going ex-ante against the EU. We would expect a strong reaction from the EU.
If Italy is allowed to go ahead with the current draft budget, the EU fiscal rules could be rendered meaningless. Other EU countries would have no incentives to meet fiscal targets based on these rules, in our view. Bailouts or ECB QE in the future will be politically much more difficult...," BofAML argues.
"Despite such concerns, investors have stopped buying but have not sold the Euro in recent weeks, according to our proprietary flows. This could reflect complacency.
Our U-shaped EURUSD projections for this year included Italian risks this fall, but we are assuming that market discipline will eventually force a compromise. This is Italy's opening position, but it is more extreme than markets have been expecting and what the EU could accept, in our view," BofAML adds.