German Elections: What to Expect

Now that the dust has settled on the Fed taper issue, EUR/USD traders are moving on to the next big event risk for the pair: the German elections.

The polls will take place this Sunday and, aside from possibly resulting in weekend gaps, it could also be crucial in determining the longer-term direction of the euro. What exactly is on the line here?

At stake is the German Chancellor position, which is likely to be secured by Angela Merkel for her third term. Let's take a look at the potential outcomes:

If Merkel wins...

A Merkel victory might ensure that Germany sticks to the status quo, as it continues to push for conditional bailouts and oppose pooling the entire euro zone's debt. Recall that Merkel has been strongly against having Germany share the same liabilities as the debt-ridden euro zone nations, such as Greece and Portugal, and has insisted on stricter bailout terms.

This should be positive for the German economy but might be negative for the euro region if debt problems worsen and periphery nations have trouble securing more funds.

If Merkel loses...

Social Democrats could gain majority and push for a joint debt repayment funds and other options that would "throw all of the debt into one pot." Alternative für Deutschland (AfD), a new party, could also gain voice. AfD wants to stop giving financial aid to the euro zone economies. This could lead to a two-speed growth in the Europe - one of the "struggling south" and the "productive north."

A victory by either party will most likely be negative for the euro. For one thing, any changes in the euro zone officials' plans could put a dent on market confidence. Ditto for any thoughts about a two-speed European growth. Last but not least, pooling liabilities could also drag Germany down.

Of course there's always the possibility of a political coalition should any party fail to secure a majority. Unfortunately, stalemates usually slow down decision-making processes and implementation of reforms, which is usually negative for a currency.

Confidence on Merkel's leadership and the desire for continuation of current policies make Merkel's win the best case for the euro right now. A win by Merkel and her party could extend the euro's gains while any other scenario could inspire deep retracements or potential reversals for the euro's rallies.