EUR/USD: Why German Politics May Add to the Euro's Woes Next Monday

© European Union

- EUR faces duo of political headaches Monday, 15, October.

- Italian budget submission lands alongside Bavaria election result.

- Bavaria poll a headache for Merkel either way the result goes say ING.

The Euro ceded further ground to the Dollar Tuesday as markets remain in dismay at the latest developments in the Italian budget saga, but another political headache awaits the single currency once into next week. 

Germans will go back to the polls on Sunday to determine which political party will lead the legislature of Bavaria, the most populous state in Europe's largest economy, which has become a key battleground for establishment and anti-establishment forces in Germany. 

The vote is being billed by analysts as one that will set the tone of German politics for years to come. It might even have an impact at the European level too. Markets will awake Monday to digest the result at the same time as Italy submits its 2019 budget proposal to the European Commission. 

Italy's ongoing budget drama has already forced the Euro back to 2017 levels beneath the 1.15 threshold as fears over the Mediterranean nation's commitment to the Euro and relationship with the European union mount. That saga will also come to a head Monday. 

The Euro-to-Dollar rate was quoted 0.11% lower at 1.1480 Tuesday and is now down 4.2% for the 2018 year-to-date.

"Be prepared for a political landslide with a long-term impact on German national politics. A dramatic defeat of the CSU would first lead to an earthquake in Bavaria, foreshadowing future political developments and structural shifts at the national level. An unexpected comeback of the CSU would probably prompt a political landslide in Berlin," says Carsten Brzeski, an economist at ING Group.

Sunday's election will pit Chancellor Angela Merkel's coalition partner, the Christian Social Union (CSU), against a series of non-coalition rivals including the Green Party, the anti-establishment Alternative for Deutschland (AFD) and the Eurosceptic Free Voters. 

Opinion polls give varying levels of support for the CSU but almost all show it lacking the 40% required for it to lead the Bavarian regional assembly.

Brzeski notes insufficient support for the CSU and flags the 18% slice of the electorate likely to back the Greens as a significant threat to the incumbents. The CSU has won in Bavaria for much of the post-war period.

"CSU tried to score by being trouble-maker at federal level," the economist writes, in a note to clients Tuesday. "The CSU’s strategy to distance itself from Merkel in order to prevent a rise of the AfD in Bavaria seems to have been a double failure. With less than 40% of the votes, the CSU is on track to come in with the worst result since 1954."

The Alternative for Deutschland, which opposes Chancellor Merkel's migration policies and has called for Germany to leave the EU, has 10% support in the polls according to Brzeski. Another Eurosceptic party, the Free Voters, also has around 10% of the likely ballot if polls are to be believed. 

These numbers are significant on their own merit but even more so after considering that polls drastically overstated support for the Green Party ahead of 2017's federal election while understating the share of federal government seats the AFD would eventually go on to win. 

Chancellor Merkel's Christian Democratic Union and Bavaria's Christian Social Union coalition won 34.7% of the seats in the September 2017 election, its worst result in post-war history, while the traditional opposition force that is the Social Democratic Party also reached a nadir of just 20%. 

"Bavaria matters. The Bavarian elections are not only important due to the sheer size of the state, with some 16% of the total German population and more than 18% of German GDP. They also matter because the CSU’s dominance – 12 absolute majorities in the last 13 elections – has been an integral part of the success of the CDU/CSU bloc in federal elections. Currently, some 20% of the CDU/CSU seats on German parliament come from Bavaria," Brzeski explains.

Sunday's ballot could mean another headache for Chancellor Angela Merkel as well as the Euro, which has been hobbled of late by an escalating war of words between the anti-establishment government in Italy and EU budget hawks in Brussels, regardless of its outcome.

This is because the message about German politics that it will certainly send, regardless of the vote, will put establishment party's backs further up against the wall sooner or later.  

"The CSU would be emboldened in its criticism of Merkel, continuing to be a permanent thorn in her side and pushing the federal government coalition closer to the edge of the cliff. As the SPD is also in a kind of existential crisis, the chances of the federal government coalition collapsing before the 2021 elections would clearly increase," Brzeski says, of the implications of a surprise win by the CSU on Sunday. 

If opinion polls are right and the CSU suffers a historic drubbing in Sunday's election, Merkel might be seen as the winner  in the short term because it could then be said that her coalition partners will have paid a price for their recent political decision to distance themselves from her. 

However, such an outcome would only serve to reinforce the Alternative for Deutschland's position as an opposition party. This could have significant implications in the next federal election, due to be held in 2021, particularly when it comes to coalition building in the wake of the vote. 

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