German election: Merkel must form coalition, rise of far-right AfD poses big challenge

Despite Angela Merkel is set for a fourth term as Germany's chancellor, judging by the ARD exit polls, the far-right party AfD (anti-immigration Alternative for Germany) is projected to win enough votes to enter the Bundestag (German parliament) for the first time in 50 years. 

Even with projections that fo from 32.5 to 33.5%, a comfortably 12p lead over the second placed Social Democratic Party with 20-21%, the AfD obtained between 13 and 13.5% support in Sunday's election.

After the disappointing results by both CDU's Merkel and SPD leader Schulz, the latter told supporters that a coalition with Angela Merkel is not an option. Merkel's CDU is now expected to form, not without months of negotiations, a coalition with the liberals and the Greens, what has been called the "Jamaica Coalition" due to the colour of the parties matching the countries' flag. 

Angela Merkel said that while the results are disappointing, they still have the advantage to govern. "We don’t need to beat about the bush, we had hoped for a better result. But we should not forget that we had a very challenging parliamentary term behind us. “We now have the task of forming a government", Angela Merkel told supporters at the headquarters of her CDU party.

As reported by Politico: "Broadcaster ARD’s exit poll shows that Angela Merkel’s CDU/CSU alliance lost 9 percentage points compared to the last election in 2013, while the SPD lost 5.7 percentage points." 

Alexander Gauland, a leading politician of AfD, noted: ”Only the idealism [of our members and followers] … Brought us here and I want to thank you for that. And, dear friends, now that we’re obviously the third biggest power … The government has to buckle up. We will hunt them. We will hunt Ms Merkel … and we will take back our country and our people.”

Mrs Merkel promised voters to recover the lost ground in upcoming elections while openly recognizing that the far-right party's entry into the Bundestag represents "a big challenge".

Mrs Merkel told supporters: "Of course we had hoped for a slightly better result. But we mustn't forget that we have just completed an extraordinarily challenging legislative period, so I am happy that we reached the strategic goals of our election campaign. We are the strongest party, we have the mandate to build the next government - and there cannot be a coalition government built against us."

Meanwhile, Social Democratic Party leader Martin Schulz, who conceded defeat, said it was an especially depressing day "due to the strength of the AfD, which for the first time brings a right-wing party into German parliament in such a strong position. This is a turning-point."

"The fact that we took in more than 1 million refugees in our country is still dividing in our country. What for some has been an act of humanity and charity is to others menacing, strange and filled with fear. We did not manage to persuade all of our voters that Germany is strong enough not to leave anyone behind" Schulz added. 

Scenarios 

Clear victory by Merkel: This is more of a same kind of situation in Germany and Eurozone. Approving bailout packages will be easy; there will be more room for Eurozone financial integration. The idea of the European monetary fund will gather traction. Finance Minister Wolfgang Schaeuble wants to run fiscal surpluses every year until 2020 and has only vaguely hinted at tax cuts. So there is little scope for fiscal reflation…

Impact on EUR/USD: mildly positive, Focus would shift to the ECB.  EUR/USD could rally sharply if Merkel changes her stance following a clear vitory and talks about reflating the economy.

Tight victory by Merkel: Polls suggest Merkel will be short of a parliamentary majority in the Bundestag and will need weeks, if not months, to form a new coalition government.

A small majority for Merkel would make her vulnerable during if there’s a new crisis in the Eurozone.

Impact on EUR: A minor initial sell-off likely. Next move depends on the sound bites - if in support of reflationary policies, EUR would rally.

Schulz win: Schulz has promised to cut taxes for anyone earning less than 60,000 euros - a measure that would benefit nine out of 10 German workers - and to reduce social security contributions for those earning up to 15,000 euros a year. Schulz also wants to spend 30 billion euros more on public investment by 2021. He wants to raise taxes for top earners.

Impact on EUR: An Intraday sell-off could be followed by a sharp rebound and rally to 1.24 handle in the subsequent days, especially if the new Chancellor talks about delivering tax cuts and public spending.