There’s an unusual calm in the derivatives markets: the majority of euro options expiring the day after Sunday’s vote tilt in favor of more gains and bearish sentiment on the common currency has faded. Stock markets are also pricing a benign outcome, with Germany’s benchmark DAX gauge at a record high.
That positioning threatens to flip painfully if the center-right CDU/CSU alliance, which has been leading polls, struggles to form a coalition. Such an outcome would likely drive the euro toward parity with the dollar as uncertainty and political horse trading with smaller parties ensues.
Societe Generale SA is recommending investors buy protection against a drop in the euro as a result, while Commerzbank AG and Credit Agricole SA are warning its clients of the risk.
“Everyone seems to be assuming that it’ll be a non-event,” said Michael Brown, senior research strategist at Pepperstone Ltd. “That sort of complacency could lead to even more of a market jolt.”
Protracted coalition negotiations — particularly if they’re held after a big surge in support for the far-right AfD party — would leave Europe in a “worst-of-all-worlds scenario,” Brown said. The knee-jerk market reaction could drive the euro below $1.03, he predicted.
The common currency was trading 0.3% weaker at 1.0473 as of 11:40 a.m. in London, weighed by a weak reading of business activity in the region. Still, the common currency is on track to gain 1% in February, its best monthly performance since August.
Michael Pfister, a currency strategist at Commerzbank, says that his base case is for a center-right alliance led by Friedrich Merz to form a government, but “an unclear majority is clearly a risk for the euro.”
Why the Euro Is Closing In on US Dollar Parity Again: QuickTake
Merz’s alliance has hovered at around 30% for months, with the AfD in second place at about 20%, according to the Bloomberg polling average. Chancellor Olaf Scholz’s Social Democrats trail in third at around 15% and the Greens fourth at 13%. Depending on how many smaller parities secure seats in Bundestag, a three-way coalition may be needed to form a government.
Confronted with those risks, options traders seem remarkably sanguine. Data from the Depository Trust & Clearing Corporation show that 60% of options that went through this year and that expire Monday are targeting a stronger euro.
The euro has moved in a range of about $1.02-$1.05 since the start of the year, and the options flows suggest investors expect it will trade toward the stronger end of that range after the vote.
What Bloomberg strategists say...
“From currencies to stocks, the markets are positioned for the German election to produce a result in line with what the polls have shown all along — effectively underpricing the risk of an upset. An election outcome that upends predictions sufficiently enough to make a viable and long-lasting coalition tricky will call into question any optimism surrounding a quick change to the debt-brake status and hurt the euro.”
—Ven Ram, Cross-Assets Strategist, Dubai. Read the full piece here.
Expectations for post-election volatility in the currency are also muted. The premium to protect against swings in the euro over a one-week period now trades around 100 basis points below the average seen so far this year, highlighting that few traders are positioned for a post-election sell off.
The relative calm contrasts with the jitters seen in the run-up to the US vote in November, when overnight volatility in the euro-dollar pair surged to its highest in more than four years.
Societe Generale says traders would be wise to snap up some euro protection in case there’s a surprise outcome. The market’s apparent confidence has left hedges looking cheap, and the French bank recommends buying options to sell the euro over the next two weeks to protect against a drop below $1.03.
Risk ‘Underpriced’
As it stands, currency and bond markets are “very underpriced” for the risk that the AfD unites with other parties to block budget reforms and higher spending, says Jordan Rochester, head of FICC strategy at Mizuho Bank Ltd.
The “worst outcome” for the euro “would be evidence of significantly stronger support for the AfD than implied by current polls,” Credit Agricole strategists wrote in a note. “This could complicate any attempts to build a coalition government consisting of mainstream parties and push the euro-dollar pair back to recent lows around 1.03,” they said.
The big-picture danger is that if coalition talks drag on, Germany won’t be able to push ahead with budget reforms and spending increases to revive the economy and boost its military budget. Trump is intent on dialing back the US’s security role in Europe, underscoring the need for European countries to commit more to protect against the possibility of future Russian aggression.
“The market seems to be in the mindset that, because you’re likely to have a coalition that wants to spend more, it’s going to happen quickly,” said Sam Lynton-Brown, global head of macro strategy at BNP Paribas, in an interview with Bloomberg TV. “But that’s not how it works in Germany. The average time for a coalition to form is more than two months.”
(Updates with latest euro price in the seventh paragraph)
