Will Merkel's Political Troubles Send EURO to 1.16?

The week of Thanksgiving is typically a quiet one for currencies because many U.S. traders are off for the whole week.  Lower liquidity however can also mean greater volatility if there's major news.  We got a taste of that today with the breakdown of coalition talks in Germany.  When markets opened for trading in Asia on Sunday EUR/USD sold off aggressively.  In early European trade, it recovered all those losses to turn briefly positive but ended up giving back all of those gains to end the day sharply lower.  Chancellor Merkel failed to secure a coalition after weeks of contentious negotiations and the talks collapsed over the weekend when the Free Democrats walked out.  Investors interpreted the political uncertainty as euro negative and rightfully so because Merkel could lose power after serving as Chancellor for the past 12 years.  The recovery during the European session was sparked by the misplaced notion that Germany's political troubles are localized like Spain's. As the largest country in the Eurozone however its troubles will have a direct impact on the currency.  The FDPs walked out, the Social Democrats refuse to form a coalition leaving Germany with only 3 choices:

1.     New Elections

2.     Merkel forms a minority government

3.     Merkel convinces FDP to return to the negotiation table

The Chancellor has said she would prefer to hold new elections than form a minority government that could face its own set of troubles.  Unfortunately calling new elections is a complicated process that will take months.  Forming a minority government or convincing the FDP to return the negotiation table won't be easy either, which is why we believe that Germany's political troubles could send EUR/USD below 1.17.  Today's cautious comments from European Central Bank President Draghi confirm that the euro won't receive any help from policy.  According to Draghi, while the ECB believes that the economic expansion is solid, they also see the need to keep an ample degree of monetary stimulus.  The most important economic reports scheduled for release this week are from the Eurozone.  November PMIs are due on turkey Thursday followed by the German IFO report on Friday.  We expect softer numbers all around but the moves should be contained to the European session as North American traders are away from their desks.  EUR/USD has support at 1.1680 but as long as there are no positive surprises in data or sudden political developments, the sell-off could extend down to 1.16.

The U.S. dollar traded higher against most of the major currencies today on the back of rising yields. The most important piece of U.S. data scheduled for release this week will be Wednesday's FOMC minutes and they should be hawkish as the Federal Reserve prepares to raise interest rates next month. So it should be no surprise that the greenback is bouncing after a difficult week especially with USD/JPY finding support at 112.00. The latest Japanese economic reports also contributed to yen weakness with the trade balance shrinking significantly in the month of October as import growth rises and export growth slows. We were a bit surprised by the lack of reaction to President Trump's decision to declare North Korea a state sponsor of terror.  The White House is also expected to announce new sanctions on Tuesday.  The lack of reaction come from investors being more worried about military action than economic sanctions but regardless, these steps increase North Korean tensions and invites a response from Kim Jong Un. Fed Chair Yellen also submitted her letter of resignation, in which she says she will step down once her term ends in February.

The only currency that outperformed the greenback today was sterling, which is surprising given the lack of U.K. data or news.  Sterling is trading purely on the hope that there will be progress on Brexit talks this week.  Prime Minister May is expected to officially increase Britain's divorce payment.  There's been talk that they could double the initially proposed amount in an effort to unlock the talks but nothing official has been announced.  Unfortunately those rumors circled around paying the entire EUR60 billion Brexit bill and the latest reports suggests that May would receive approval to increase her offer to about EUR40 billion.  The European Union barely budged on their requests throughout the talks and they may not be satisfied with this number. Just this morning the EU's chief negotiator said Britain would lose single market access post Brexit even though Britain hopes to maintain it.

All 3 of the commodity currencies traded lower against the greenback today with USD/CAD recapturing 1.2800. The 5th round of NAFTA talks, which wrap up on Tuesdayhave failed to yield any meaningful results. The U.S. is pushing for tougher automotive content rules that basically call for a greater share of the value content of all North American built autos to be produced in the U.S. Canada and Mexico are standing their ground, offering counter-proposals and rebuttals.  We're not sure how much progress will be made in Round 6 early next year but Canada and Mexico are hoping that the U.S. will bow to domestic pressure from lawmakers and commerce.  Although Canadian yields rose firmly today, USD/CAD was driven up by the stronger U.S. dollar and lower oil.

The focus now shifts to the Australian dollar with the Reserve Bank of Australia minutes scheduled for release this evening.  When the RBA last met, they left interest rates unchanged.   According to Governor Lowe, the bank's forecasts for growth are largely unchanged with a brighter outlook for non-mining business offset by low wage growth and uncertainty in household consumption.  At the time, the Australian dollar sold off because the central bank failed to change its GDP forecast and expressed some concerns about low inflation.  However the main takeaway from the meeting and tonight'sminutes should be that the central bank is comfortable with the current level of policy and have no plans to change it anytime soon.  RBA Governor Lowe will also be speaking during the London trading session. A stronger U.S. dollar and weaker New Zealand data forced the New Zealand dollar to give up all of its earlier gains.  Food prices declined and service sector activity slowed in the month of October. Dairy prices are due for release tomorrow and investors will be watching carefully to see if prices stabilize or fall further.