Merkel victory as expected, but coalition caution weighs on euro

The euro has opened 0.4% lower in early trading on Sunday evening as the market digests the results from the German election. Although Merkel will become Chancellor for her fourth term, Merkel’s party - the CDU - saw its vote share slip by approx. 8%, about the same as the Far Right’s AfP’s vote share increased. Merkel’s victory speech was humble; she stressed her disappointment at not winning a larger share of the vote, which may have spooked the FX market during the early Asia session.

Coalition horse-trading to begin

The other factor that is weighing on the markets is that the SPD, Germany’s second largest party, had an extremely disappointing evening, winning 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.

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. Added to that, 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.

Why the euro decline could be reversed

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. 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.

Equities: mild reaction to German election

The Dax is currently expected to open lower according to the futures market, however the futures market is predicting relatively subdued moves across Europe at the start of this week, and we anticipate that the reaction to Germany’s election result will be mild. However, if a coalition with the business-friendly FDP is confirmed, then we could see the Dax strengthen back to the June highs just below 13,000 initially. The Dax had been flat lining in the days leading up to this election, rising by approximately 60 points last week, which suggests that there could be a short burst of volatility now that the result is known. We believe that the FDP is likely to push for cuts to the corporate tax rate, which would have broad benefits for all of the sectors’ in the Dax, and could see the German index play catch up with its Italian counterpart the FTSE MIB, which has been the best performing European index so far this year.

Wrap up

Overall, we believe that the German election result is good for the Dax, and tonight’s decline in the euro is an over-reaction that could be reversed once European markets open on Monday morning. However, we note that it is central bankers’ and not politicians that are the key drivers of the FX market right now, and Yellen, Draghi and Carney have much more influence over the direction of the euro in the coming week than Germany’s political landscape.