Fundamental Analysis

Euro Weighed by German Political Uncertainty, Looks to Eurozone Flash PMIs for Support

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The euro is once again dogged by political risks as the collapse of the coalition talks in Germany has raised the prospect of months of uncertainty in the Eurozone's biggest economy. The announcement on Monday of the collapse of the three-way coalition talks between Chancellor Angela Merkel's party, the CDU/CSU, the pro-business Free Democratic Party (FDP) and the Green party, has driven the euro to a one-week low of $1.1712, shifting the near-term risks for the currency back to the downside.

The failure to form a coalition is a serious blow for Merkel, whose party had its worst election performance in September since 1949. Germany's president, Frank-Walter Steinmeier, is urging all parties to resume talks but there are few hopes of any deal being struck. It is thought it is unlikely for the FDP to return to the negotiating table after unexpectedly pulling out of the talks. The Greens have accused the FDP of trying to oust Merkel as Chancellor.

Merkel could now try to form a minority government, with the possible backing of the Greens. However, Merkel has already hinted that she would prefer to have fresh elections, with the aim of achieving a strong and stable government, than to run a minority government. But with the President reluctant to call new elections, the possibility of some sort of a compromise between the parties cannot be dismissed. The FDP's withdrawal from the coalition talks may now put pressure on the Social Democrats (SPD) to reconsider reviving their 'grand coalition' with the CDU/CSU.

Although the SPD leader, Martin Schulz yesterday ruled out entering another coalition and voiced his support for snap elections, the threat of voter punishment for forcing new elections could yet see the party find itself being lured into a new grand coalition, especially if Merkel was to offer significant concessions to secure a deal. The same can be said for the FDP.

The most probable outcome however, is a fresh election. Under German law, the process of calling a snap election could take weeks, suggesting the current political stalemate is unlikely to be resolved before the end of the year. This could weigh on the euro and deepen the currency's downward correction from the 32-month high of 1.2092 set in September. A re-test of November's 3½-month low of $1.1552 would become highly likely under such a scenario.

However, strengthening economic fundamentals for Germany and the Eurozone, mean downside moves are likely to be limited. Eurozone PMI data due on Thursday should serve as a reminder of that. The region's composite PMI is expected to stay unchanged at 56.0 in November's flash reading. The index hit a six-year high of 56.8 in April and May and combined activity in services and manufacturing has held near those highs since.

The euro could also find support from Friday's Ifo business survey out of Germany. The Ifo business climate index hit an all-time high of 116.7 in October and is only forecast to fall marginally to 116.6 in November.

While the euro area's improving economic landscape does not appear to be at risk from developments in Germany, any early sign that the political situation is starting to dent business confidence in the country could put a damper on wider investor sentiment in the region. This could prove a catalyst for a sharper sell-off in the euro. But for now, the single currency has underlying support from expectations of a gradual removal of monetary stimulus by the European Central Bank over the coming year.

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