EUR: New theme alert – fiscal risk premium – ING

The euro is looking soft on the crosses and a new theme may be coming into play on the back of geopolitical developments. US isolationism means that Europe is going to have to ramp up defence spending sharply. The question is: who's going to pay for it? Will spending be undertaken at the European supranational level? Or will a failure to reach any collective agreement put pressure back on local and national budgets, ING’s FX analysts Chris Turner notes.

EUR/USD to stall in the 1.0450/70 area and can drop to 1.0350

"Italy could be in focus here with perhaps one of the greatest needs to increase defence spending but a debt-to-GDP ratio already close to 140%. Our rates strategy team feels that the recent narrowing in Italian-German sovereign bond spreads could well reverse as it dawns on investors that national governments will be paying the defence bill."

"Some of these trends started to show through in financial markets yesterday, where European debt really started to underperform. We are seeing a bearish steepening of European bond curves, where the German 2-10-year Bund curve, now at 38bp, has steepened to the highest levels since October 2022. We are wary that the theme of increased government bond supply can pressure peripheral spreads and demand a new fiscal risk premium of the euro."

"This comes at a time when there is not much trade risk premium priced into EUR/USD either. As above, there do not seem any immediate signs that the US consumer is about to crumble or that the Fed is about to pull the trigger on another rate cut. Overall we have a slight preference that EUR/USD stalls in the 1.0450/70 area and could drop to 1.0350 should we start to see Italian longer-dated government bonds coming under pressure."