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Optimism Reigns as Berlusconi Faces Test

NEW YORK (BBH FX Strategy) -- Markets remained cautiously optimistic ahead of today's Italian parliamentary vote on public finances, which threatens to topple Prime Minister Silvio Berlusconi.

European stocks are rising, with the Euro Stoxx 600 rebounding (up 1.4%) from a two-day decline, after Asian shares traded defensively overnight. European bank shares are up nearly 2.0%.

Italian Premier Silvio Berlusconi

Eurozone finance ministers last night discussed details for the leveraging of the European Financial Stability Facility to 1 billion euros, now hoped to be in place in December. Both the insurance model and the SPV to attract outside investors remain on the table.

Despite the recent pressure on the EZ sovereign debt market, Greece was able to sell 26-week bills at 4.89 and the Italian 10-year yield is lower on the day. The EUR/CHF saw choppy action amid comments from the SNB's Jordan, indicating that the SNB's policy action is dependent on deflation.

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Italian politics remains in the spotlight. The Italian bond market's off-the-run 10-year yields are currently at 6.591%. The Italian government will submit a routine budget for Parliament to vote today, with Berlusconi attaching a confidence vote to a failed budgetary outcome. From there, if the government fails to reach a majority of 316 votes for a confidence vote, Berlusconi will be forced to resign his post.

Ahead of the vote, speculation about the prime minister's imminent departure is rife and markets have welcomed the prospect. In Italy's fragmented political landscape, his departure would not necessarily mean that austerity measures will pass quicker.

If the Berlusconi government falls, the first choice would likely be to see if a new coalition government can be formed with the existing parliament. This is likely to be supportive of risk appetite in the short term, but it would end quickly if a coalition could not be formed and the fall in the government were to lead to elections. This would ultimately delay the passage of the austerity measures and sap business and investor confidence even further.

Nevertheless, from here the best outcome for market sentiment in is likely to be a resignation of Berlusconi followed by the formation of a new government from the existing parliament. Looking ahead we still expect the euro to come under pressure with a short-term target near 1.3650, but we acknowledge that we could see the euro get a short term boost from today's vote with resistance expected near 1.385.

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