German Elections 2021: Traffic Lights
Euro area politics took a slight turn for the better during the past week, following the outcome of the German elections. Voters ordered the continuation of centrist policies, listing climate change as a top priority. A (small) leap towards further European integration is likely.
The Social Democratic Party (SPD) won the popular vote (25.7%), the first time since 2002, with the CDU/CSU block second with 24.1%. The SPD validated its improvement in the past two months, while the CDU/CSU block suffered considerable losses compared with the 2017 elections (-9 pps).
The Greens received a record 14.8% of the votes (from 8.9% in 2017) and the liberal FDP 11.5% (from 10.7% in 2017). The far-right AfD fell to 10.3%. Note that the far-right AfD was third in 2017 (12.6%), entering the Bundestag for the first time in 60 years, as the migration crisis has taken its toll on mainstream parties. Finally, the Left Party received 4.9%.
Both the SPD and the CDU/CSU block fell short of an overall Parliamentary majority. A “Traffic Light” coalition between the SPD, the liberal FDP and the Green Party appears the most likely scenario, under Olaf Scholz. The other option is a “Jamaica” coalition between the CDU/CSU, Greens and FDP under Armin Laschet (Merkel’s successor).
Negotiations will be difficult and will likely run to end year. On Monday, euro and Bund yields were broadly flat. Specifically, the euro declined by -0.1% against the USD, to $/1.17 and the 10Yr Bund yield ended the session at -0.22% (up by 18 basis points Month-to-Date). The DAX40 increased by +0.3%, in tandem with European markets. The avoidance of a more left-leaning Government (R2G) and the likely inclusion of pro-business FDP could be equity market supportive.
Global bond markets came under selling pressure due to the modest hawkish shift among central bankers (Fed, Bank of England), with high equity duration sectors (e.g. Technology) ending in the red. Concerns driven by developments in the property sector (China) receded, albeit risks did not disappear. A sharp housing market correction or continuous funding pressure in the highly leveraged property sector could pose financial stability risks.
The Fed maintained the Federal funds rate (FFR) at 0.25%, as expected, but the split vote in 2022 (9 out of 18 participants forecasted at least one hike vs 7 three months ago) was more hawkish than expected. The interest-rate outlook for the medium term reveals a FFR of 1.8% (2024) versus a long-term (or natural) rate of 2.5% suggesting that policy is expected to remain accommodative.
Having said that, inflation is likely to be the determining factor for the pace of interest rate hikes, with risks skewed to the upside amid skyrocketing commodity prices.
The Fed also sent a strong hint that will begin its portfolio normalization (current pace of purchases: $120 bn per month) in November/December, ending large-scale net asset purchases by mid-2022. The Fed decision pushed the 10Yr UST yield up by 11 bps to 1.48% (three-month high), while the 10/2 curve steepened (118 bps). Rates’ volatility could increase ahead of the US legislative “perfect storm” (funding bill to avoid a Government shutdown that would kick in Friday morning, infrastructure and social security bills and lifting the debt ceiling).