Euro Drops On Disappointing Data And Rising Borrowing Costs For Italy- What's Next?

The euro was pushed further into the $1.20's against the US dollar yesterday after Italian borrowing costs rose at a debt auction and industrial production in the euro-area registered bigger than expected drop, while US retail sales rose at the fastest pace in five months.

Manufacturing output in the euro-zone declined by 0.4% m/m in January, compared with a forecast of -0.1% m/m and following the upwardly-revised 0.9% m/m increase in December.

The Italian Treasury sold two-year notes at 2.48%, higher than the 2.30% at a previous auction. Investors also demanded a higher 4.90% premium for Italian bonds maturing in 2028, compared with 4.80% prior yield for securities with the same maturity.

In contrast to the disappointing euro-area data, US retail sales beat the consensus forecasts for 0.5% m/m increase, rising by 1.1% m/m in February. The US dollar attracted more bids on signs that the recovery in the world's largest economy is gaining traction.

Uncertainty about the future of Italy could add more pressure on the single currency in the days ahead.

A week after Fitch cut the country's credit rating, the new Italian parliament gathers this Friday, March 15 for its first session following last month's inconclusive election. The Democratic Party is struggling to form a coalition, desperately trying to reach an agreement with Beppe Grillo's anti-establishment Five Star Movement. However, Grillo has been very clear about his opposition to an alliance with any of the main parties and has said that his movement wants to lead the next Italian government.

It seems highly unlikely that a workable coalition will be formed and this could push Italy one step closer to a new election later this year. In other words, we could be looking at months of uncertainty about Italy's future, which could spook investor sentiment and could lead to rising borrowing costs, risk aversion and more euro weakness.

The euro is breaking below last week's support at $1.2954, reaching as low as $1.2922 today and looks positioned for a challenge of the double bottom at $1.2875, established in December, 2012. A breach of this level could open the door to a test of $1.2803 and possibly the November 13, 2012 low at $1.2659.

Disclosure: None.

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