German Politics and the Euro

The euro’s rally is looking stretched – will Germany’s uncertain political outlook be the catalyst for a reversal?



The stability of the euro is built upon a foundation of German political stability.  Membership of the single currency includes many countries who, prior to the euro’s introduction, were not known for either prudent currency management or political stability (the two often go hand in hand). It is safe to say that, were the euro considered a ‘new lira’, rather than a (admittedly imperfect) proxy for the Deutschemark, then its reputation in the FX markets would be significantly less than what it is today.  As such, it is noteworthy that the current rally in the euro is coinciding with an uncharacteristic bout of German political turmoil. 


The recent rally in EURUSD has it hovering just below 1.20. There is little doubt what is driving this upward momentum – the European economy has been outperforming expectations at a level not seen since the Greek bailout in 2010 (when expectations were extremely depressed). 


Chart I: Citibank Economic Surprise Index




However, even ignoring the potential implications of German political instability, the current euro rally looks like it might be getting stretched.  The rise in the euro has caused the single currency to look overvalued compared to the yield spread (chart II).  In the past, such divergences have led to substantial corrections in the euro (indicated by the red circles).


Chart II: EURUSD (blue, rhs) vs EUR/USD 10 year yield spread (red, lhs)



In addition, speculative market positioning is heavily skewed towards EUR buyers – in fact, hedge funds have only ever been this long the single currency once before (see chart III) – a classic signal of a potentially overcrowded trade.


Chart III: CFTC Net Long Positions, Speculative Accounts




Combine these market signals with an uncharacteristic bout of German political instability, and it becomes difficult to see how this current rally can sustain itself much further. 


It has now been almost two months since the elections, and German voters still don’t have a new government.  If such political uncertainty were to occur elsewhere (the UK, for example) it is difficult to imagine that FX markets would be as forgiving as they seem to be here. In the short term, this market complacency may be justified – it now seems that a return to a ‘grand coalition’ of Merkel’s conservatives and the Social Democrats (SPD) is the most likely outcome of the current political mess.  Such a result (while still far from certain) may result in a short-term boost for the euro, as FX traders tend take comfort in political continuity almost as much as they rue uncertainty. 


Such an outcome would, however, plant the seeds for future political turmoil for Germany, and for the euro zone.  This outcome would see the eurosceptic and hard right Alternative for Deutschland (AfD) party become Germany’s main opposition party.  The Free Democrats (the business friendly, mildly eurosceptic party which scuppered the recent coalition talks) would also remain outside the government.  This political dynamic would further serve to reinforce the split in German politics surrounding the issue of European integration, which bodes ill for the optimistic vision of Europe painted by Emmanuel Macron, and the development of a truly fit-for-purpose currency area.


Author: Kevin Lester




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