Merkel's coalition attempts seen weighing on euro in short term

(Bloomberg) The euro may weaken short-term and peripheral bond yield spreads widen as the rise in popularity of a far-right party in Germany’s election threatens to undermine efforts for closer European integration.

The shared currency declined against all except one of its Group-of-10 peers after the weekend vote saw Alternative for Germany, or AfD, post a surprisingly strong result. That cast a shadow over Chancellor Angela Merkel winning a record-equalling fourth term. While analysts said the drop in the euro and German bund yields may prove short-lived amid a spate of speeches by European Central Bank policy makers this week, Merkel’s coalition talks and political uncertainty in Spain and Italy still pose a risk to the outlook.

The results also serve as a "wake-up call" to those who thought the threat of populism in the European Union had subsided after the win for pro-euro Emmanuel Macron in May’s French Presidential election, according to Société Générale SA strategist Kit Juckes. The euro could fall toward $1.17 in coming weeks, he said.

Benchmark German 10-year bunds rose Monday, pushing the yield spread with comparable Spanish bonds to 122 basis points as of 4:18 p.m. in London, the widest in two weeks. The complexities involved with forming a ruling coalition in Germany could "restrain the euro-area spread tightening in coming months," according to analysts at Commerzbank AG, including head of fixed-income strategy Christoph Rieger.

Here’s a roundup of analysts’ views for the euro and the region’s bonds:

Commerzbank

The result "looks set to pose headwinds to the yield convergence in euro bond markets as the FDP will insist on red lines in Macron’s plans for deeper euro integration and political uncertainty will increase in coming months," Rieger writes in a client note dated September 25.

Given the contrasting views of the parties who could form a coalition with Merkel’s party "political uncertainty looks set to increase as a government formation will become very difficult" over coming months.

Still maintains a "more constructive stance for now" and "larger set-backs should be seen as opportunities to add risk" amid the backdrop that the ECB is "expected to give more indications that it is able to dilute QE rules".

Rabobank International

The German election results also may cause markets to "infer that the political backdrop in the euro zone is still disjointed and continues to pose a threat to investment potential medium-term," London-based senior currency strategist Jane Foley writes in a note dated September 25.

Going forward, the euro is also likely to be susceptible to political news from Spain and Italy.

EUR/USD "could be choppy around current levels on a one- to three-month view".

Forecasts EUR/USD to move toward $1.22 on a six-month view. but "European politics constitutes a risk to this outlook".

The election result poses "a challenge in terms of re-convergence trades," write Rabobank strategists headed by Richard McGuire in a separate note. 

Upside potential for peripheral spreads is limited with 100bps in 10-year Spain versus Germany looking "harder to break".

Rabobank suggests "160bp may provide some sterner resistance as regards 10y Italy-Germany".

ING Groep NV

The "shift to the right" in the election has ramifications for Europe such as fiscal integration and future debt renegotiation, says Martin van Vliet, senior interest-rate strategist at ING.

At the margin, spreads could come under some "widening pressure" and bunds rally but van Vliet said that volumes on Monday are fairly light, i.e. "these moves are not backed by flows in the secondary market".

The coalition taking time to form is less of an issue than the fact that there is a right-wing party in parliament and the coalition partners have differing views.

For van Vliet, the Italian elections pose the "biggest hurdle".

Expects more volatility in the run up to the vote.

Yield on 10-year bunds could rise above 0.5% ahead of the Oct. 24 ECB meeting. 

Toward the end of the year, the yield could slip back below 0.5% ahead of the Italian election.

Standard Bank Group Ltd.

Expects EUR/USD to "slip back to the 1.15 level – or lower – through to the end of the year as the rally to our longer-term target of 1.30 is delayed," writes Steve Barrow, head of G-10 strategy, in a client note.

One factor would be dollar strength on the back of tax reforms in the US, while the euro is weighed by the recent "political strain in the eurozone".

While the German election temporarily has taken "the shine off the euro" the Catalan referendum in Spain could further unsettle the currency.

Standard Bank is bullish the euro in the longer term but for now says "euro/dollar is more likely to slide back to the 1.15 area than rise to 1.25".

Danske Bank

The elections could mean a prolonged "period of heightened political uncertainty in Germany over the coming weeks as coalition talks drag on," write strategists, led by Arne Lohmann Rasmussen.

At the margin, the election could make Germany more euro-sceptic and "provide less tailwind to periphery markets".

But the effects could be short-lived as the AfD could face isolation post a coalition being formed.