Pound 0.5% up on the Euro as Germany Faces Prolonged Political Horse-Trading but Weakness Predicted to be Short-Lived

• Spot Market FX Quotes:
• Pound-to-Euro exchange rate: 1.1378, +0.72%, day's best: 1.1385, low: 1.1279
• Euro-to-Pound exchange rate: 0.8788, day's best: 0.8854, low: 0.8782

Image (C) European Commission.

The Euro exchange rate complex was softer at the start of the new week with analysts citing the outcome of the German election as a reason.

The Euro Index - a broad measure of overall Euro performance - was down 0.30% in early London trade on what appears to be a hollow victory for Merkel in the German elections.

The market is digesting results which saw Chancellor Angela Merkel ultimately secure an historic fourth term but her mandate has been hollowed out by her party having recorded its worst result since 1945.

Merkel’s CDU party saw its vote share slip by about 8% which is similar to the increase in vote share enjoyed by the Far Right’s AfP.

The problem for markets is the uncertainty posed by the horse-trading required by Merkel to form a Government.

The SPD, Germany’s second largest party disappointed having secured only 20% of the vote, much less than had been anticipated by the polls.

Although they could have formed a coalition with Merkel’s CDU Party, which would have been a smooth way for Merkel to form a government, they have ruled themselves out of power and said that they will remain in opposition for Merkel’s fourth term as Chancellor.

“This leaves investors’ facing a period of uncertainty as Merkel tries to form a coalition government with the smaller parties,” says Kathleen Brooks at City Index.

Most analysts believe coalition talks are likely to centre on the “Jamaica” coalition, made up of the CDU, FDP and the Green Party, which would scrape Merkel through to power with just over a combined 50% of the vote.

The head of the FDP and the head of the Green Party have both said that they are ready to hold coalition talks and take on the responsibility of government.

“If this positive momentum continues then a coalition deal to be sewed up fairly quickly, which could have a calming effect on the markets and ensure that volatility in German stock markets remains subdued,” says Brooks.

However, Christian Gattiker, Chief Strategist and Head of Research at Julius Baer warns of a tedious negotiation process that should last well into the year-end. Accordingly tax cuts and stimulus spending decisions are likely delayed into 2018 while the European reform project might see some delays too.

"Uncertainties are Bund-friendly, peripheral bonds unfriendly, neutral for equities and negative for the Euro," says Gattiker.

"Coalition talks will be very difficult due to fundamental differences on key policy areas, such as the environment and defence," says Stefan Schilbe, Economist with HSBC Bank in Germany.

But most analysts expect the damage inficted on the Euro to be relatively limited as there are no significant policy implications delivered by the result.

“If the Euro has been falling on the back of concerns about the good performance from the Far Right AfP party, who won 13.5% of the vote making them the third largest party in Germany, then this is unlikely to have a lasting negative effect on the single currency," says Brooks.

“No other party in Germany will form a government with the AfP, so even though the party has won its first seat in the Bundestag, they are not going to get into power. We would expect any residual fears about the AfP to fade once Europe gets in tomorrow morning, which could trigger a reversal in this early decline in the Euro,” adds Brooks.

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Pound-Euro Exchange Rate Looking Bullish

While some speculate the Euro's weakness to be short-lived, the outlook for GBP/EUR is looking increasingly positive.

"With German politics in a state of flux and US politics increasingly fraught, suddenly the UK looks a bit of a stable safe haven after Mrs May's speech on Friday. Although it hasn't unlocked doors, it’s been seen as a step in the right direction away from the likelihood of a hard Brexit," says Jim Reid, Strategist with Deutsche Bank.

From a technical perspective, if we look at the charts we do see GBP/EUR is at a key point.

The 1.1370-1.14 region is providing a solid range of resistance with selling pressure on Sterling growing in this region. Indeed, we have been here five times in the past seven trading days.

Will a break occur this week? If it does then the prospect of another leg higher becomes likely.

Our week-ahead technical studies suggest the Pound could be getting ready for another rally versus its counterpart having observed a bullish flag formation on the daily charts.

1.1480 and then 1.1830 are seen as being potential targets.

“As analysts respond more positively to pound, they will be watching closely to see how it responds to events in the Eurozone, as the impact of the new German government is felt. If the influence of new voices in the German parliament is clear within Eurozone policy, then investors could view the pound more favourably!” says Paresh Davdra, CEO of foreign currency brokerage RationalFX.

Get up to 5% more foreign exchange by using a specialist provider by getting closer to the real market rate and avoid the gaping spreads charged by your bank for international payments. Learn more here.