Euro on Back-Foot as German Politics Enter "Unprecedented Situation"

Above: Angela Merkel's future at the head of the German government now looks less certain. Image (C) European Commission.

Currency's dislike political uncertainty, it's therefore understandable that the Euro is struggling on news that negotiations to form a coalition government in Germany have broken down.

The Euro starts the new week softer on news German Chancellor Angela Merkel's efforts to form a three-way coalition government have failed leading to the creation of what the country's President described as "an unprecedented situation in the history of the Federal Republic of Germany."

German President Frank-Walter Steinmeier painted a gloomy picture of Germany's political limbo on Monday having met German Chancellor Angela Merkel and has pledged to get all parties to continue to talking.

The President - who is largely ceremonial - appears keen to avoid another election, but fresh elections in Europe's largest economy might have to be run again if talks do not yield results.

Merkel’s attempts to form the "Jamaica" coalition in Germany have failed as the pro-market Free Democrat Party (FDP) walked out of talks citing irreconcilable differences with the Green Party.

Former coalition partners the Social Democrat party have of course previously ruled out forming a grand coalition with Merkel's ruling CDU/CSU, suggesting there are few options left for Merkel.

"The Euro is starting the week on a fragile note," says Philip Wee, FX Strategist with DBS Group Research. "With the prospect of a strong German government diminished, it has eroded the lift that the Euro found from last week’s better-than-expected German GDP data."

The Pound-to-Euro exchange rate is trading at 1.1245, having opened the week at 1.1206. The Euro-To-Dollar exchange rate is trading at 1.1789, exactly where it commenced the week's trade.

Currencies dislike uncertainty, and it is therefore understandable that the Euro would start the new week on the back-foot on the latest news out of Germany.

However, whichever shade the eventual German Government acquires it is likely to be resolutely pro-European which means substantial damage to the Euro is likely to remain limited.

"In these circumstances, it is understandable that there has been a knee-jerk Euro sell-off as the outlook for German politics is now more uncertain. This could contribute to a greater focus on domestic politics at the expense of external issues such as closer European integration and Brexit. Nevertheless, the immediate impact on the Euro is likely to be limited," says Lee Hardman, Currency Analyst with MUFG.

Some Hope

The Euro did manage to recover some lost ground in the mid-day session on headlines out of Germany suggesting all is not lost for Merkel.

The Free Democrats have apparently signalled that they could support a minority government made up of Merkel's CDU-CSU bloc and the Green party.

FDP parliamentary director Marco Buschmann told the Bild newspaper that:

"If there are good initiatives, then we are available."

This is clearly a fast-moving situation so we would suggest all we can really guarantee is heightened volatility.

Indeed, the element of political risk in Euro exchange rates could grow further over coming days and weeks should the issue of German leadership deteriorate.

Merkel said she would stay on as acting chancellor and would consult with President Frank-Walter Steinmeier on how to move forward, adding that a deal had been within reach.

“It is a day of deep reflection on how to go forward in Germany,” Merkel told reporters. “As chancellor, I will do everything to ensure that this country is well managed in the difficult weeks to come.”

Analysts at Helaba Bank, based in Frankfurt, warn the Euro could further weaken "during the day over uncertainty on the political future in Germany."

"Short-term, these developments might be positive for Sterling and negative for the Euro," says Piet Lammens, an analyst with KBC Markets in Brussels.

From a Sterling-Euro perspective, Lammens does however confirm that longer-term, "a political stalemate in Germany probably also won’t make the Brexit process easier," something we have reflected on here.

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.