Reuters News - EU election casts shadow over euro zone as ECB meeting approaches

A man casts his vote for the European Parliament and Belgium's general elections in Deurne near Antwerp May 25, 2014.

CREDIT: REUTERS/FRANCOIS LENOIR

(Reuters) - Investors this week will be watching the results of elections that could deal a blow to political parties that are key to reform efforts in the European Union and could also fan instability in Ukraine.

The bonds of some struggling euro zone governments sold off last week as investorsworried about expected gains for anti-EU parties in European Parliament votes in Greeceand Italy.

In Greece, a strong showing by parties opposed to the terms of its EU-led bailout may hurt the fragile coalition government, potentially paving the way for a new national vote.

In Italy, a poor result for Prime Minister Matteo Renzi's party could undermine his drive for swift reforms, which he promised when he took power in a party coup earlier this year.

The rise of anti-EU parties in northern Europe could make it harder for the European Union to deal quickly with any future resurgence of the euro zone crisis, analysts said.

"It looks like we are going to see the far-right parties making further gains and it is going to make it more difficult for the European authorities to deal with any subsequent euro crisis events," said Victoria Clarke, economist at Investec.

Elections for the European Parliament were held from May 22 to 25.

Ukrainians vote in a presidential election on Sunday and if favorite Petro Poroshenko falls short of an absolute majority, market jitters could grow ahead of a second round of voting on June 15.

Tensions between Ukraine and Russia have escalated in recent months, with Kiev accusing Moscow of sowing deadly disorder in its mostly Russian-speaking east, where pro-Moscow separatists have declared independence and asked to join Russia.

"(If) we head to a second-round vote ... then we might find that we see risk assets suffering in the process until some form of stability has been put in place. So that could be a couple of quite painful weeks and would, if anything, reinforce the case for ECB policy easing on June 5," said Clarke of Investec.

The European Central Bank is widely expected to cut interest rates then, a Reuters poll showed, having clearly flagged that possibility at its last monetary policy meeting.

All this means a three-day ECB forum in Portugal that starts on Sunday and features president Mario Draghi and several ECB board members will be keenly watched by the markets.

Euro zone money supply data on Wednesday and Italian and Spanish inflation numbers on Friday may reinforce the case for more easing if they come in weak.

"The euro area's economic recovery is bedding in, but inflation is well below the ECB's target and there is a risk that deflation could take hold across the region," Standard Chartered said in a research note.

"This could elicit more expansionary policy."

EXIT STRATEGY

But David Mackie, chief European economist at JP Morgan does not expect an ECB rate cut in June to be the start of a sustained campaign to provide more stimulus.

"We have not changed our broad macro story, which is that the region is heading towards a 2 percent growth environment," he said. "So we don't think that what will happen in June would then be followed by more aggressive action later in the year."

In contrast to the ECB, both the Bank of England and the Federal Reserve are considering their way out of their stimulus programs as their economies recover, even though U.S. data is expected to show contraction in output in the first quarter.

But the housing market, which is strengthening in Britain and losing steam in the United States, could yet complicate matters for both central banks, analysts say.

Britain has said it will use mortgage lending controls before resorting to interest rates to cool the sector. BoE Governor Mark Carney is due to speak on Tuesday evening.

But the U.S. housing market may yet require more help from the Fed.

"Both central banks are putting together their strategies for exiting the ultra-loose monetary policy that we've had over recent years but at opposite ends of the scale in terms of their considerations for the housing sectors," Clarke said.

"In the UK, the talk is about whether there is a possible housing bubble and in the States (it) is virtually the opposite ... the Fed has the problem of working out whether its housing sector can withstand a policy tightening probably in the early part of next year."

Housing data from both countries this week could shed further light on this, with British Bankers Association's mortgage lending data due on Tuesday followed by statistics on the Help to Buy mortgage guarantee program on Thursday.

In the United States, the house price index is due on Tuesday and pending home sales on Thursday.

A second estimate of U.S. gross domestic product on Thursday is expected to show the economy contracted 0.4 percent in the first quarter - when much of the country was bit by fierce winter weather - from a previous reading of 0.1 percent growth, according to a Reuters poll.

National Australia Bank said a soft reading in the first quarter would not change the outlook for the Fed which is scaling back its bond-buying.

Japan also releases a slew of data this week, including retail sales, inflation, unemployment, and industrial output.