Markets Insight

September 23, 2013 3:06 pm

Merkel win marks end of eurozone’s summer lull

A strong, centre-right German chancellor rides the euro storms and secures re-election – unlike counterparts across much of the rest of the continent.

Angela Merkel’s sweeping victory on Sunday might appear to have the ingredients for a significant market rally. Since the second world war, the Dax share index has risen strongly on the election of Christian Democratic governments.

However, the muted market reaction the morning after the night before betrayed investors’ worries about the next chapter in the eurozone debt crisis, which begins with Ms Merkel’s return to the Bundeskanzerlamt. The Dax index refused to show even a flutter of excitement; Bunds also held steady.

For the next few weeks at least, German politics and Berlin’s stance on the eurozone will be unclear. The collapse of the Free Democratic Party, Ms Merkel’s preferred coalition ally, means she must now find a way of working effectively with political opponents.

A “grand coalition” between her CDU and the Social Democrats was – and still is – the dream outcome of markets. Even if more leftist and regulation oriented, the assumption is that such a pairing would make Berlin more eurozone periphery-friendly, smoothing the eventual resolution of the region’s crisis.

A CDU/SPD coalition worked in the recent past and is the most likely outcome. It is not a certainty, however. Moreover, the balance of risks may actually be skewed towards Berlin maintaining or even hardening its stance on the eurozone – which would threaten to drive up yields again on Italian and Spanish debt.

Ms Merkel will see the CDU’s strong showing – its share of the vote was the highest since 1994 – as vindicating her tactics of demanding a quid pro quo from weaker eurozone states for German munificence. The Social Democrats (and Greens) know that debt mutualisation is deeply unpopular with Germans.

When the Christian Democrats helped design the eurozone’s institutional architecture in the 1990s, their intention was that discipline imposed by financial markets on governments would compensate for the lack of European political union. That proved wishful thinking. Before the crisis, markets barely distinguished between different governments’ bonds. But the thinking behind the Maastricht treaty, which paved the way for the euro’s launch in 1999, still influences the CDU, whose ministers now face a host of issues left pending during the election campaign, including possible new bailout programmes for countries such as Greece and Portugal.

Bending Ms Merkel’s ear will be Jens Weidmann, her former economic adviser who now heads the Bundesbank, the country’s central bank. With appetites for greater European political union remaining weak, despite all the turmoil of the past few years, he argues publicly for reforming the continent’s monetary union in such a way as to ensure market forces can work effectively. A less polite way of putting it would be: keep up the pain.

In a little noticed speech in August, Mr Weidmann urged the appropriate “risk weighting” of sovereign bonds on banks’ balance sheets – it should cost more to hold the debt of less creditworthy governments. The idea would be to break links between the fates of governments and their financial systems, and encourage fiscal discipline. Although innocuous sounding, the impact could be explosive in weaker countries where banks’ balance sheets are stuffed with their national government’s bonds.

Eurozone markets, meanwhile, await the verdict of Germany’s constitutional court on the backstop the European Central Bank has provided since the middle of last year. The ruling, expected before the end of the year, is unlikely to torpedo the ECB’s “outright monetary transactions” programme, by which the central bank stands ready to buy the debt of distressed governments. So far, the mere possibility of OMTs has calmed markets without actual activation. But any reservations expressed by the Karlsruhe judges could raise doubts about the programme’s effectiveness and set the tone for the broader debate on crisis management in Berlin.

Eurozone bond yields, which move inversely with prices, are already under upward pressure as the world gets used to the idea of the US Federal Reserve scaling back its asset purchases, or quantitative easing. Last week saw a relief rally as “tapering” was delayed. But the danger is high of Fed action inadvertently imposing tighter monetary conditions prematurely on the weak eurozone economy. During the past few months, periphery yields have remained remarkably steady. Germany’s election may have marked the end of the summer lull.

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