Watching the price action of EUR/CHF, Italian 10-year government bond yields, and a number of European equity indices, I see ominous signs that all is not healthy in Europe.
If the macroeconomic backdrop were stable and rosy, EUR/CHF should in all probability trade to 1.20, the previous level the CHF was pegged to the EUR before the Swiss National Bank (SNB) was forced to remove the currency peg in 2015. Then, the EUR was depreciating rapidly with the European Central Bank (ECB) pushing for a powerful dose of Quantitative Easing (QE).
In order to defend the peg, the SNB had to burn through foreign exchange reserves to weaken the CHF more than the EUR, a feat that proved to be too costly in the end.
Times are a-changing and now the ECB is set to end its QE programme in December. Interest rates should remain unchanged at -0.40% until summer 2019, according to Draghi, but it is clear the ECB is on the verge of tightening its monetary policy. This is in direct contrast with the SNB, which has repeatedly reinforced its stance to keep interest rates low due to weak inflationary pressures.
This means the SNB will in all probability not raise its benchmark interest rate at least until the ECB makes the first move. Given this dynamic and contrasting monetary policies, market forces should push EUR/CHF back to the 1.20 psychological level.
Now, that did happen this year, albeit very briefly. Since then, the technical chart for EUR/CHF has looked horrid. As seen below, a massive head and shoulders bearish pattern has developed, with the demarcated neckline around 1.1450. Since dipping below 1.12 a few weeks back, EUR/CHF has gone on to re-test the neckline, but price action has rebounded off it, finding tough resistance there.
Price Chart: EUR/CHF
Amongst the FX pairs, the CHF (and JPY) have safe-haven asset status. It is very telling that something ominous is on the horizon if the CHF - a negative-yielding currency at that - is rapidly gaining demand against the EUR, keeping in mind that both the ECB and SNB are on divergent monetary policy paths.
Where could the trouble be emanating from?
As written in my earlier article "Italy's Budget Squeezing EUR/CHF," the budget situation in Italy has sent alarm bells going off in Europe. Europe has seen a wave of populism sweep through its lands, as witnessed by populist parties gaining power in Italy, namely the Five Star Movement and The League.
Matteo Salvini and Luigi Di Maio have utilised their charm and cunning to great effect, promising extraordinary welfare measures in exchange for votes, which will no doubt weigh on Italy's creaking budget. Their proposed budget will lead to a government budget deficit of 2.4%, almost thrice the target set by the previous administration. This has put Italy on a collision course with the European Commission, with Italy 10-year Government Bond yields rising to levels last seen in 2014.
Higher yields could be a function of the central bank working to raise interest rates, in the case of the Federal Reserve. In this case however, rising yields have been due to investors downsizing their exposures to Italian government bonds on fears the country's debt situation will worsen.
Price Chart: Italy 10-year Government Bond Yields
In the chart above, I have demarcated a crucial level (2.50%) that Italy 10-year government bond yields have broken through. Yields breaking out of the multi-year range is a key sign that they are set to rise higher.
From a bigger perspective, the wave of populism sweeping through Europe might well be a very prevalent issue in the years to come. Rising levels of immigrants have not sat well with many countries - Italy being one of them, and the Five Star Movement and the League have harnessed this anger to maximum effect.
Angela Merkel should know best. Her resignation came after a particularly bruising regional election, where voters had expressed deep dissatisfaction with her immigration policies.
What does this mean for equity markets then?
I am seeing very bearish patterns across a huge number of European equity indices. Below I have demarcated the necklines of bearish head and shoulder patterns in Germany's DAX 30 (DAX), The Euro Stoxx 50 (FEZ), France CAC 40, and Italy's FTSE MIB. You can see that price action has rolled below the aforementioned necklines, which signals a high probability of more downside to come.
Price Chart: Germany's DAX 30
Price Chart: Euro Stoxx 50
Price Chart: France CAC 40
Price Chart: Italy FTSE MIB
Italy's FTSE MIB chart looks the worst of the lot, which is not surprising given the turmoil in Italy. Should the wave of populism continue to take its toll in the region, European equities will no doubt be hit further. Although equity markets have somewhat recovered from October troughs, bearish technical charts in the currency, government bond, and equity indices signal more weakness ahead.
I would suggest to investors to make use of the recent rally in global equities to lighten up on equity positions. I recommend placing a short EUR long CHF trade, to sell EUR/CHF at market (1.1390), with a stop loss above 1.15 (which would see price action break above the neckline at 1.1450), accompanied by a take profit target at 1.1150 (2018 lows).
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.