Euro’s Destiny Depends On More Than Merkel’s Mindset

Taylor Scott International News By Ralph Atkins in London Federal Reserve, not German election, will determine interest rates Since the eurozone debt crisis erupted almost four years ago, national elections have proved cathartic moments – and often buying opportunities for investors. The contest for Germany’s chancellorship between Angela Merkel, the incumbent, and Peer Steinbrück, her Social Democratic challenger, may be short on daily, market-driving dramas (this is a German election). Polls suggest Ms Merkel is sure of re-election. But the September 22 vote will be long on significance for the eurozone and financial markets – even if, depressingly for German politicians, the world’s central banks ultimately prove more important in determining the eurozone’s destiny. Ahead of François Hollande’s election as France’s president in May last year, French stocks were falling sharply but within a few weeks were on a sustained rally. The CAC 40 index is 25 per cent higher than the day Mr Hollande was elected. More remarkably, inconclusive Italian elections earlier this year marked a turning point for southern eurozone sovereign bond markets. Italian yields, which move inversely to prices, fell sharply after February’s poll as the extended political stalemate in Rome failed to become the disaster investors feared. The case for Germany’s election proving an inflection point rests on the idea that a re-elected Ms Merkel will be less hawkish on the eurozone: that she softens her stance on fiscal austerity and becomes more like Helmut Kohl, her Christian Democrat predecessor and erstwhile mentor, in driving forward Europe’s economic integration at German taxpayers’ expense. Ms Merkel wants to govern again with the centre-right Free Democrats, her existing coalition partners. The case for expecting a sea change in German thinking might appear more compelling given that a weak FDP vote could force her into a “grand coalition” with the centre-left SPD, which is keen to express solidarity with weaker eurozone neighbours. On such rosy assumptions, yields on eurozone periphery debt could have further to fall. True, German yields would rise as capital flowed into weaker economies and European growth prospects brightened, inflicting losses on German bond holders. But as a nation of savers, Germans would cheer higher domestic interest rates. Historically, the Dax share index has rallied on Christian Democratic victories; this time equities might surge across Europe. But there are a lot of snags with such conjecturing. For a start, Ms Merkel’s strong personal poll ratings owe a lot to her handling of the euro crisis and insistence on a quid pro quo in terms of deep structural reform from countries benefiting from German munificence. A change of character after September 22 seems unlikely. The risk remains that Alternative für Deutschland – the fledgling eurosceptic movement which wants to dissolve the euro – wins representation in the Bundestag, gaining an important public platform. If the AfD did jump the 5 per cent voting threshold, the parliament’s arithmetic would make a “grand coalition” more likely. But even a grand coalition could disappoint markets; for all its sympathy with weaker eurozone economies, the SPD is as keen as others to reduce Germany’s debt burden. Once the elections are over, a host of eurozone issues on hold during the campaign will resurface, whether the strains in the bailout programmes for Greece, Cyprus, Portugal and Ireland, or the restructuring of Europe’s banks. With an emboldened, freshly re-elected Merkel, the potential for eurozone upsets may simply rise. As crucially, Germany is voting at a time when the US Federal Reserve is turning the tides in capital markets. Until May, French and Italian financial assets were riding the waves created, first, by the European Central Bank’s pledge last year to prevent a eurozone break-up, then by the Fed’s unlimited “quantitative easing”. Since the Fed announced plans to scale back, or “taper” its asset purchases, however, bond yields have risen globally. The risk in Europe is of monetary conditions tightening prematurely – and dangerously in the eurozone periphery. What happens next to borrowing costs will probably depend more on the outcome of the Fed’s two-day policy meeting starting on September 17 than the German elections five days later. All the above does not mean markets are wrong in turning more optimistic on Europe. Bunds have decoupled a little from US Treasuries – the rise in 10-year German yields has not been as steep since May. Mario Draghi, ECB president, is attempting to use “forward guidance” on official interest rates to keep the recovery on track. Strong purchasing managers’ indices this week show growth becoming established. The recent sell-off in emerging markets has increased the attractiveness of European assets. But Ms Merkel’s mindset will be only part of the story. Taylor Scott International

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