German Election Relief Rally as Coalition Talks Begin

The German elections unfolded largely as expected by opinion polls, prompting a relief rally as the arduous phase of forming a coalition government begins.

Keeping to the Centre

The results of the German elections held yesterday, Sunday, largely aligned with the projections made by opinion polls. The centre-right CDU-CSU confirmed the highest share of seats in the Bundestag at 28.6%, positioning Friedrich Merz, its leader, as the frontrunner to form a new government and become the presumptive Chancellor. However, the vote distribution does not provide a clear path for forming a coalition government. The second-largest party, the far-right AfD, obtained 20.8% of the votes, doubling its performance from the previous election. Nevertheless, all major parties have stated that they will not work in coalition with the AfD, leaving Merz to cobble together a multi-party coalition, which could potentially lead to renewed government instability if the right-wing CDU has to collaborate with the left-wing SPD and Greens, for instance.

Merz had previously ruled out forming a "grand coalition" between the two major parties, the CDU and SPD, as this combination has been unpopular in the past. However, in light of the results, he has now suggested a preference for working with a two-party coalition and hopes to complete the negotiation process by Easter. Analysts expect that the coalition talks could take up to two months, with the current Chancellor, Olaf Scholz, remaining in office as a caretaker.

The Market Moves

Apparently, there were concerns that the election results might deviate from the poll predictions, given the relief rally that occurred once the results were announced. The EURUSD reached its highest level for the entire month, European stock futures surged, and yields on German bonds (Bunds) stabilised, with some of the movement in the euro attributed to weakness in the dollar. However, it appears that the absence of "nasty surprises" in the election results reassured and the increased confidence in the prospect of a more pro-business government taking over. The remaining issue, though, is the debt brake, with Merz opposed to its reform – and changing it would require a two-thirds majority in the Bundestag, in any case. The election results seem to have pushed the potential reform of the debt brake to the back burner for now.

The Chancellor-in-waiting delivered a speech as the results were announced, recapping priorities for his new government. Geopolitics took centre stage as he vowed to work towards European unity and pivot away from the US, aiming to achieve "real independence" from the world's largest economy. Merz is also notably more hawkish on foreign policy, supporting the provision of long-range missiles and increased support for Ukraine.

EURUSD C&Hs Emerge

The EURUSD has left behind two cup-and-handle patterns, a medium-term and a shorter-term one, with both facing resistance at 1.051. The handle height of the longer-term pattern opens the door to 1.063, matching the previous resistance. However, if supports at 1.045 and 1.04 weaken in case of a pullback, EURUSD could decline towards 1.03.

Source: SpreadEx / EURUSD

Key Takeaways

The German elections developed as forecasters expected, resulting in a relief rally in EURUSD as markets cheered the prospect of a pro-business government under Merz. However, the coalition negotiations could take their toll, and Merz's opposition to making reforms to the debt brake could limit fiscal policy changes. Meanwhile, his hawkish foreign policy stance signals a pivot towards greater European independence from the US.