BMPS Banca Monte Dei Paschi Di Siena Spa

By Georgi Kantchev 

The euro rallied from early losses, following Italian voters' rejection of a government-backed referendum, but the volatile day raises concerns about how the currency survives an era of populist politicians and diverging economies.

The euro was at $1.0765 late Monday in New York, up 0.9% against the dollar. Overnight, it had been down as much as 1%. The referendum's failure meant the resignation of Italian Prime Minister Matteo Renzi. Mr. Renzi's antagonists, the antiestablishment 5 Star Movement, have questioned the common currency and called for a nonbinding referendum on Italy's membership in it.

The referendum sets up a political vacuum in Italy that could be treacherous for the country's banks. A plan to rescue the weakest, Monte dei Paschi di Siena SpA, is likely scuttled, and it may need to be nationalized. If other banks stumble, and if concerns rise for banks outside of Italy, the euro could be stressed further.

European stock markets rose Monday, except for Italy's, which was hurt by sharp falls in banking shares and ended down 0.2%.

Monday's calm trading, outside of Italian banks, suggested investors believe the vote on its own doesn't challenge the eurozone. There was no clamoring for havens: Long-term German bonds weakened, as did gold. Italian bonds also fell, and their yields rose more than Germany's. That gap signals some concern about Italy, though the gap widened only modestly.

Born in 1999, the euro has survived tougher trials. In 2010, its member countries set aside deep resistance to paying for each others' debts and bailed out Greece and then Ireland. The next year, Portugal. And in following years, Spain, for its banks, and Cyprus.

The left-wing Syriza party took control of Greece in 2015 full of rumblings about a return to the drachma. Yet Greece stomached capital controls and a new bailout and didn't leave the euro.

For investors, however, the repeated tests erode confidence and reawaken existential questions. "We've seen these games many times before," said Richard Benson, co-head of portfolio investments at Millennium Global Investments in London. "The euro recovers, but each of these political events goes by and the eurozone takes another hit, so one wonders how long this can be sustained."

And next year will pose many more tests. Elections will come in 2017 in Germany, France and the Netherlands. Consulting firm Bain & Co. has told clients to "withhold new investments" in Western Europe, warning that a breakup of the euro is likely.

An eventual fracturing of the common currency would likely be a calamitous event for financial markets. Widespread capital controls would be needed to prevent destabilizing rushes of money from countries deemed likely to have a weak posteuro currency to those expected to have a strong one. Huge swaths of financial infrastructure, including derivatives markets and common banking systems, would need to be disaggregated.

Indeed, fears of the chaos even one country's exit would cause proved to be a powerful glue holding the eurozone together during its debt crisis. Since then, there has been a flurry of changes meant to bind it still tighter, most notably, closer and more consistent supervision of banks, which triggered trouble in Ireland, Cyprus and Spain, and tougher fiscal rules, whose transgressions were the undoing of Greece and Portugal.

Yet the work isn't fully done: The Continentwide "banking union" is still elusive, and there is little movement toward the more-distant goal of the sort of federal treasury and budget that redistribute money across the 50 states of the U.S.

And with a host of euroskeptic parties braying at the heels of governments now, the prospects for either have receded further.

The euro, as a financial instrument, has declined since early 2014, when it was near $1.40. But that shift has been led by a sharp divergence in monetary policy: The U.S. Federal Reserve is moving away from monetary easing, while the European Central Bank is deep in an experiment of negative interest rates. To a large degree, a weak euro is a good thing for the eurozone's efforts to build exports and return ultralow inflation to healthier levels. Analysts said that monetary-policy split will continue to keep the euro depressed, but that politics is looming as a force.

"The euro is in a downward spiral," said Francesco Filia, who manages $300 million as head of Fasanara Capital in London. Mr. Filia is betting that the euro will fall against the dollar as France's elections draw closer. "Ultimately, we are very bearish for the prospects of the European Union surviving the next couple of years in its current form."

To be sure, the eurozone's demise has been predicted many times before. The currency enjoys solid popularity among Europeans who use it. And while euroskeptic parties have made strides in opinion polls, they have had less success reaching public office in the eurozone. On Sunday, Austrians voted against a far-right populist candidate for the largely ceremonial post of president.

"Unless and until an antieuro group is running a euro-area government, outcomes like today create intraday volatility rather than trend euro weakness," said John Normand, head of international foreign-exchange and rates strategy at J.P. Morgan Chase & Co.

Several analysts said the euro could reach parity with the dollar next year. That hasn't happened since 2002. Before the referendum, Deutsche Bank AG forecast the euro would fall to $0.95 by the end of next year, while Citigroup Inc. foresees the euro tumbling to $0.98 in the next six to 12 months.

"The euro is a politically driven currency now," said Dominic Bunning, senior foreign-exchange strategist at HSBC Holdings PLC. Mr. Bunning said he has been recommending clients bet against the euro since before the referendum, partly because of the rise of euroskeptic parties.

A mitigating factor for the euro might come from an unexpected place, a strengthening European economy. There are tentative signs that the eurozone, which has been plagued by low growth and high unemployment since the financial crisis, is turning the corner.

The unemployment rate across the 19 countries that use the euro fell to its lowest level since mid-2009 in October, while retail sales rose at the fastest rate in more than two years that month, according to official statistics.Manufacturing and consumer optimism have also rebounded, data show.

The end of a long period of economic weakness could give the ECB enough comfort, eventually, to pull out of negative rates and slow down or stop its bond purchases. That would boost the euro. Another effect of a strengthening economy may be to dull the disintegrationist push of populist parties.

The next big test for Europe could come from France, a country that has helped push eurozone integration. Current polling suggests that the far-right National Front leader Marine Le Pen is a leading contender in France's presidential election next year, though she isn't the favorite. Ms. Le Pen wants to pull France out of the euro.

Mark Dowding, co-head of investment-grade debt at BlueBay Asset Management LLP, has sold French bonds in recent weeks ahead of next year's presidential elections.

"Italy voting out Renzi is one thing, but if the French were to vote for Le Pen, it could be the beginning of the end for the euro," he said.

--Christopher Whittall, David Wighton and Ira Iosebashvili contributed to this article.

Write to Georgi Kantchev at georgi.kantchev@wsj.com

(END) Dow Jones Newswires

December 05, 2016 19:32 ET (00:32 GMT)

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