German Political Risk Tipped to weigh on Euro vs. Pound Sterling and US Dollar Over Coming Days

- Tensions in ruling German coalition tipped to keep Euro on defensive this week

- EUR/USD could hit 1.1510, GBP/EUR could rise to 1.15

- Berenberg say failure of government unlikely

Image © Stefan Yang, Adobe Stock

Trade tensions and political uncertainty in Germany are seen as potential risks for currency markets to watch at the start of the new week, and "both factors might be intrinsically negative for the Euro," warns analyst Piet Lammens with KBC Markets in Brussels.

A retest of the 1.1510 correction low in EUR/USD remains possible warns Lammens, while he expects EUR/GBP to be found around the mid 0.87 area which implies a GBP/EUR towards 1.15.

German political risks are centred around the future of Angela Merkel's current coalition government: Minister of the Interior Horst Seehofer, who is also the head of key ally and coalition partner the CSU, has drawn a red line over current German immigration policies.

Seehofer, facing state elections later in the year, knows he must represent a more robust approach to immigration if he wants to fend off the advance of the right-wing AfD party. As such, he wants all immigrants arriving at Germany's borders to be returned to the European nation at which they first registered.

The stance is at odds with current government policy and there has been talk of an imminent collapse of the coalition government over the matter.

"German Chancellor Angela Merkel faces the worst crisis of her almost 13 years in office. If the Bavarian CSU does not agree to any compromise on migration policy, her current government may fall apart shortly," says Dr. Holger Schmieding at Germany's Berenberg Bank.

Current government policy is that asylum seekers already registered elsewhere in the European Union still  be admitted into Germany where their situation can then be assessed, including a possibility to send them back to the EU country they came from.

The CSU now demands that these people should be refused entry at the border.

CSU leader Seehofer claims that, in his capacity as minister of the interior, he can order the federal police to change the practice at the border even against the will of Chancellor Merkel.

"If he does so, Merkel may need to dismiss him," says Schmieding.

The CSU may then follow its leader Seehofer and walk out of the government in Berlin. Without the 46 votes from the CSU, a coalition of Merkel’s CDU (200 seats) with the SPD (153 seats) would be two seats short of a majority in the 709-seat Bundestag.

"I expect EUR to come under pressure as Chancellor Merkel faces dissent within her fragile coalition. It took several months for her to form a government in the first place," says Marshall Gittler at ACLS Global.

However, damage to the Euro is largely limited at this stage with markets adopting something of a wait-and-see approach: The Pound-to-Euro exchange rate is quoted at Merkel is being quoted at 1.1439, having been as high as 1.1456 earlier in the day. The Euro-to-Dollar exchange rate is at 1.1571, having been as high as low as 1.1566.

Berenberg's Schmieding does however maintain he still considers the failure of the German coalition as unlikely; "whereas the rebellious CSU may burnish its conservative credentials by loudly insisting on a tough line, it would have too much to lose from shattering its longstanding alliance with Merkel‘s CDU."

Indeed, CSU leader Horst Seehofer told the Bild am Sonntag newspaper: "no one in the CSU is interested in bringing the chancellor down, or dissolving the CDU/CSU parliamentary partnership or destroying the coalition.”

"We expect the CDU and CSU to defuse their dispute within the next two weeks as all sides would have too much to lose from an escalating conflict. Still, the risks are not negligible," warns Schmieding.

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Escalating Trade Tensions

As mentioned at the start of the article, concerns over the direction of global trade relations will likely be another potential weight on the Euro over coming days.

As a response to the US move to levy tariffs on $50bn of Chinese goods, China said on Friday that it will impose tariffs with "equal scale, equal intensity" on US imports and cancel its earlier trade commitments.

"Amid growing signs of escalating trade tensions between the US and China, market risk sentiment has started the week on a soft note. Most Asian equity markets are down, while US Treasury yields are lower," says Nikesh Sawjani, an analyst with Lloyds Bank.

Where US tariffs are aimed to curb China's industrial advancement, Chinese tariffs are primarily aimed at hurting the commodity producers of the American heartland.

The first wave of 25% tariffs will hit $34bn in goods and take effect on 6 July, with another $16bn still to be reviewed.

"Trump pledged more penalties if China follows through and we see a high likelihood that he will increase the amount of Chinese imports subject to tariffs to $150bn quite soon," says a note from the research desk at Danske Bank.

In this environment of tit-for-tat we would expect the US Dollar to be dominant, and the Euro to struggle.