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Jane Foley, Senior FX Strategist at Rabobank explains that German Chancellor Merkel may have won her fourth term in power but it is the far-right AfD’s success in becoming the third largest part in the Bundestag that has stolen the headlines this morning. 

Key Quotes

“The implication is that the next few years could be tough for Merkel.  Markets may also infer that the political backdrop in the Eurozone is still disjointed and continues to pose a threat to investment potential medium-term.”

“By the time Macron won the French Presidential election in the spring, the consensus view about political risks in the Eurozone had been dampened considerably.  At the end of last year, the market were concerned about the rise of a divisive brand of populism in Europe and was fearful that this would extend to countries such as the Netherlands and France.  Although the sharp rise of Macron’s political party displays all the hallmarks of populism, his brand was built around reform and support for EMU.”

“For investors, Macron was the presentable face of populism in a way that Germany’s AfD is clearly not.  Even though claims from the AfD’s Pazderski that the party represents a conservative call for “qualified and balanced immigration” offers an explanation as to why the party won so much support at the weekend’s election, the calls from the AfD’s Weidel to make good on a promise to initiate a parliamentary inquiry into Merkel and her refugee policy hints that the next term in government could be particular tough for the Chancellor.”

“An immediate focus for both Merkel and the markets will be her coalition talks. This morning the spread between Bunds and peripheral Eurozone bond yields widened as investors digested headlines that Merkel may now have to commence coalition talks with the Free Democrat and Green parties; whom have differing views on issues that include European reforms.  In tune with this the EUR has also maintained a softer tone this morning.”

“Going forward the EUR is also likely to be susceptible to political news from Spain and Italy.  Headlines over the weekend suggested that Spain’s central and regional Catalan governments were battling for control of the regional police force.  This is in reference to the October 1 independence referendum that the central government has declared illegal.  This morning, Bloomberg news is reporting that Catalan police have been ordered to continue following orders from Spanish prosecutors.”

“Just as political dis-harmony threatens to make a come-back in the Eurozone, the market has been adjusting its expectations regarding the prospect of another Fed rate hike by year end following on from last week’s FOMC meeting.  While it is our view that the Fed will bow out from announcing further policy tightening this year in the wake of stubbornly low inflationary pressures, market expectations in favour of such an event have increased.”

“CFTC positioning data suggest that towards the start of last week, speculators had built up a notable amounts of short USD positions, some of which were likely reversed post the FOMC.  This week brings the publication of the US Aug PCE deflator.  Given the degree of USD shorts in the market, any uptick in this data could also lend renewed short-term support to the greenback.   On balance, we are of the view that EUR/USD could be choppy around current levels on a 1 to 3 mth view.  While we are forecasting a move to EUR/USD1.22 on a 6 mth view, European politics constitutes a risk to this outlook.”

 

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