Euro to Remain “Nervous and Volatile” as German Election Uncertainty Continues

Europe's single currency is seen on the back foot in the short-term although strategists are still upbeat about the medium to long-term outlook. 

Currency markets are underestimating the threat of a new election in Germany, according to strategists, and the Euro is likely to remain “nervous and volatile” as the deadlock becomes increasingly apparent during the months ahead.

Chancellor Angela Merkel has four options to move forward after coalition talks fell apart Sunday although neither is seen yielding a favourable outcome and the risk of further gains for anti-establishment forces in any fresh election could keep the Euro on the back foot for the foreseeable future.

“We think that markets are underestimating the risk of new general elections in Germany, which may be called for early next February,” says Chiara Silvestre, an economist at UniCredit Bank.

A grand coalition between former governing parties the CDU, which is Chancellor Merkel’s party, and the SPD would be the most palatable outcome for markets but the SPD has already ruled out this option regardless of whether there is a changeover of the guard at the top of the CDU. .

“Markets are long enough on the common currency at the moment, as IMM weekly data on noncommercial commitments indicate, and this may increase the risk of correction from time to time,” adds Silvestre.

With a resumption of coalition talks aside, other options available to Chancellor Merkel are limited to leading a minority government or pursuing a fresh round of elections. President Steinmeier, Germany’s head of state, will now mediate between the parties to find a way forward.

“On balance, we think that EUR-USD will probably remain more nervous and volatile than anticipated over the next few weeks,” says Silvestre.

Above: EUR/USD shown at hourly intervals. Captures 

If Chancellor Merkel is to lead a minority government, which she has already ruled out, she would need a presidential nomination and have to secure the backing of 50% or more of German MPs in a parliamentary vote.

The voting process could take around 60 days and if at the end of this time, a minority government has not been formed, a new election would be a near certainty.

“Whatever President Steinmeier decides to do next, the risk is that progress on Eurozone issues slows down, including Brexit negotiations,” says Robin Winkler, a strategist at Deutsche Bank.

Junior coalition partner, the FDP, walked away from talks Sunday citing irreconcilable differences between parties for having abandoned efforts to form a coalition. Talks had gone on for more than four weeks after September’s election returned a hung parliament.

“This frustration could translate into more ‘protest’ votes for the AfD in a potential snap election,” says Robin Winkler, a strategist at Deutsche Bank. “The market reaction to their surprisingly good result in the September election suggests that further gains by the AfD could undermine the narrative of declining Eurozone populism that has helped the common currency over the course of 2017.”

Above: EUR/USD at daily intervals. Captures September election reaction and recent trading.

Quite apart from the risk of another “populist” surge, a new election is seen as unlikely to break the deadlock given that opinion polls still put all parties on the same numbers as they already achieved in the September election.

“While German business leaders will express their frustration with the political stalemate, the actual impact even on the German economy should not be exaggerated,” says Winkler.

The German economy grew at an annualised pace of 2.8% during the third quarter while economists still see the economy expanding by 2% or more in 2018, regardless of the what happens in Berlin.

“The breakdown in German coalition negotiations is a marginal negative for the Euro and, via the Brexit nexus, for the pound. But uncertainty remains very high,” says Winkler.

Renewed political uncertainty in Germany is also a risk for the Pound and Brexit talks give that it could encourage the German contingent of Brussels’ team to play hard ball around the so called “divorce bill”.

With Brussels facing a budgetary black hole after the UK’s departure from the EU, the danger for Chancellor Merkel is that Germany is then expected to fill the gap, something unlikely to go down well with the German electorate.

Above: Pound-to-Euro rate at hourly intervals. Captures response to Sunday's announcement.

“It is still possible that the outcome will be more positive than a 'Jamaica' coalition might have been. And even if the stalemate in German politics continues for months and results in a snap election as late as spring 2018, we do not consider it a main risk for EUR/USD,” says Winkler.

A minority government could sound a death knell for those hoping the passing of the German election could lead to another bout of “European integration”, given it would leave the German leadership without the necessary majority to push more contentious legislation through parliament.

“On the more positive side,” says Winkler. “It is possible that the premature demise of the ‘Jamaica’ coalition could result in a more pro-European government between CDU/CSU and the Greens.”

Winkler flags scope for another election, or a renewal of coalition talks, that could punish the FPD for the uncertainty its decision has thrown up while returning a pro-European contingent to power that may be able to push ahead with further Eurozone integration.

In any case, and with short term volatility aside, neither Deutsche Bank nor UniCredit see any adverse consequences for the Euro over the medium term.

“We do not think that unexpected political uncertainty in Germany would derail the EUR-USD convergence to its fair value of 1.25 that we expect in 2018, given strong EMU fundamentals and a US dollar that is still overvalued,” Silvestre writes, in a recent note.

The Euro-to-Dollar rate was quoted 0.25% higher at 1.1769 during early trading in London Wednesday while the Pound-to-Euro rate was marked 0.24% lower at 1.1257.

Above: Pound-to-Euro shown at daily intervals. Captures September and recent trading.

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