Last Sunday, after much internal party wrangling, the Social Democrats opted by a relatively small majority to begin coalition negotiations with the CDU/CSU. However, that does not mean a relaunch of the grand coalition is a done deal. Besides major policy divisions between the three mainstream parties, the SPD leadership will also need to persuade rank-and-file party members that renewed cooperation with the conservatives is the way to go. Should the coalition talks fail, Germany would have two options – both of them historic: the formation of a minority government (led by the CDU/CSU) or new elections.
Investors in German government bonds have so far shown themselves to be unfazed by the political impasse in the wake of the general election. If, in contrast with previous (market) expectations, talks between the two big parties prove fruitless – with the result that Germany is still without a government with a working majority six months after the election – unease among EMU investors could increase slightly. In particular, investors will be worried about a continued stalling of the EMU reform process and also about a negative impact on the Brexit negotiations.
Yet given the capital markets’ inherent faith in Germany’s democratic political institutions, fresh elections would not necessarily lead to a lasting increase in risk aversion on the bond market. Instead, the political future of Chancellor Merkel is likely to be the more pressing concern. Even speculation that Merkel could consider stepping down from the chancellorship would be enough for a rise in risk aversion among EMU investors. In terms of bonds, this is likely to spark a flight to safer havens such as German government bonds; at the same time, periphery bonds could come under pressure. Investors’ prime concern would be that a new head of government from the conservative camp might take a more hardline European policy stance.