Euro struggling to maintain boost from German election.

German election: worst outcomes for EUR avoided, but path to fiscal expansion remains uncertain.
The German election avoided both the “nightmare” and “double nightmare” scenarios I outlined last week, if only by the narrowest of margins. The headline is “relief” because the CDU/CSU bloc will be able to form a government if it can get the SPD on side, which is likely if difficult as the two parties disagree on many issues. This avoids the CDU/CSU having to seek help from the Greens in what would have been an even more awkward three-way coalition. Often, forming coalitions can take several months, but CDU leader Merz, who will be the next Chancellor, has declared a desire to form a government within two months – the urgency is clear.

Merz said after the election results were emerging that Germany will "achieve independence" from the US as President Donald Trump is "largely indifferent to the fate of Europe". We can expect that the Trump administration’s policy toward Europe will be one of maximum retaliation if Europe decides it wants to go its own way and doesn’t want to sign up for a US-centric “Grand Macro Strategy” as Michael Every calls it, which would only be about extending the EU friendly terms if the EU services US national economic security imperatives. We’re still waiting for Trump’s threatened tariffs on the EU - will the EU side allow itself to be bullied on trade policy with the US and for example to change its Digital Markets Act and Digital Services Act, which target US internet monopolies?

Outside the trade policy showdown and partially related status of that issue with the commitment of the US security umbrella, the most pressing questions for Germany and for Europe are on the fiscal front. Merz has acknowledged the need for more investment in infrastructure in Germany and the EU and Europe’s desperate under-investment in defense capabilities are painfully clear, especially should NATO partially or fully collapse. But to get on the road to a massive fiscal expansion is not in Germany’s traditional mindset outside of emergencies like the pandemic. The new leadership will have to dance around “debt-brake” rules to even unlock budget deficits beyond 0.35% of GDP because the parties likely to support overturning the debt-break don’t have two-thirds majority. Two ways it could do so are supposedly via “off-budget” funds for investments or declarations of emergency, so it can be done, but can it be done at scale with an awkward center-left-center-right coalition. Equally, at the EU level, the talk is of a large fiscal expansion of EU-issued euro bonds to build more credible “hard power” as Sir Alex Younger calls it, to defend Europe. Can this most bureaucratic of institutions move at anything resembling speed and make efficient and productive investments in more credible defensive capabilities? For a significant and secular move higher in the euro, both German- and EU fiscal cylinders will need to fire in unison.

The EU will convene a “special summit” on March 6.

The German election details if interested: Of the centrist parties, the FDP collapsed by failing to clear the 5% threshold for representation in the Bundestag, the CDU/CSU bloc underperformed the polls a bit with 28.5% of the vote (29-30% in polling), the SPD was in-line with expectations at 16.1% and the Greens stumbled worse than expected to a 11.6% result. Beyond the centrist parties, the right-populist AfD performed at the strong end of pre-election polling and got 20.8% of the vote and has promised to be a loud opposition party to the government. The leftist BSW, with 4.97%(!) just missed the 5% threshold, which was the key development opening the door for a CDU/CSU government with the SPD. The other leftist Die Linke polled strongly with nearly 9% of the vote.

Chart: EURUSD
EURUSD mounted a challenge at the range high and high for 2025 at 1.0533, but failed to do so and has now erased its positive reaction to the German election, although risk sentiment in equities in Europe today is happy with the outcome (some relief on avoiding the most awkward of coalitions, perhaps). Until we get a firmer signal from Europe on how Germany plans to get around its own debt-brake rules as outlined above and we see a committed EU-level plan to build a more robust defense, the euro may continue to languish against the other major currencies. Risk of a steeper sell-off if the selling takes out the recent 1.0401 low, possibly opening for 1.0200 again, with strong close above 1.0500 needed to keep the focus higher.