EUR/USD Forecast: Trading the Italian elections and the German coalition decision

• Sunday, March 4th, features two key political events in Germany and Italy.
• Not all the scenarios are priced in and could impact the Euro in the wake of the new week.

Here is what to watch out for in chronological order: Germany first and then Italy. Within the scenarios for each country, we start with the more probable and move to the extreme options. Each scenario is accompanied by the potential impact for the Euro.

Grand German coalition - priced in

The center-left German SPD party publishes the result of its postal vote regarding participation in another alliance with Angela Merkel's CDU/CSU coalition on Sunday, March 5th. An approval by approximately 464,000 eligible members would result in the official formation of a new Grand Coalition (GroKo in German).

This would not only be a continuation of the current, mainstream government that markets want but even a more favorable one for markets. According to the coalition agreement, Merkel will lead a more pro-European government this time, in line with French President Macron's aspirations for further integration.

After the elections in September, the SPD initially rejected another such coalition, as the party has been punished by voters for this outcome. Since then, Merkel tried and failed to cobble a "Jamaica" coalition with the liberal FDP and the Greens and eventually brought the SPD back to the negotiations table. Markets cheered on that news and were also happy with the agreement that was ultimately reached.

However, voters were not happy. According to recent polls, the SPD is losing ground after making the U-turn. Also, a group of young SPD members is campaigning for a rejection of yet another coalition. A media report suggested that no less than 24,000 people joined the SPD's ranks to vote against such a coalition. The party is also lacking a clear leader after Martin Schulz stepped down as party leader. Merkel's party approved the deal earlier in the week.

Markets are pricing in a vote in favor of a Grand Coalition in line with the wish of the leadership. In case this is indeed the result, it is favorable for the EUR/USD, but as it is already priced in, the focus shifts to the Italian elections.

No GroKo - Low probability, high risk - three bad scenarios

In case the SPD members reject the deal, it would deal a blow to stability in the euro-zone\s largest country and economy. It would weigh heavily on the EUR/USD and would likely overshadow the Italian elections. This is a low probability but high-risk event.

1- Minority government: In this case, one option would be for Merkel to try to form a minority government. This would be unprecedented in post-war Germany and would take time to organize. However, it could still somewhat soften the blow for the euro. 

2 - New elections: Another option is that Merkel calls new elections. This would be a worse outcome for the Euro as a new set of elections would see the rise of more populist parties. The uncertainty and the risk of a worse result would be worse for the EUR/USD.

3- Merkel steps down: The worst option would be if Angela Merkel steps down. She has been Chancellor since 2005 and a failure to form a government five months after the elections trigger a resignation. This may also come from her colleagues. Merkel is seen as the leader of the Free World in some quarters, making this scenario the worst for the EUR/USD.

It is important to stress that these options have a low probability, but the risk is high.

Italian elections - shortly after markets open

Voting in Italy ends at 23:00 local time, 22:00 GMT, shortly after the markets open. Exit polls are expected at that time with real results coming in throughout the Asian session. Another wave of responses is likely in the European open.

Assuming the SPD approves the coalition with Merkel, the focus will shift to the elections in the eurozone's third-largest economy. 

Italian politics are fragmented, and the system has been recently changed, making it harder to predict the outcome. The publication of polls is prohibited in the 15 days preceding the elections, and some 30% of Italian told pollsters they were undecided at that point. Moreover, the complicated mixed system of first-past-the-post + proportional representation makes these polls hard to analyze.

Even though uncertainty is high, the risks are not as elevated as they used to be. The more extreme parties, namely The League and the 5-Star Movement, have moved away from suggesting an exit of the euro-zone. Nevertheless, stability is necessary due to the size of the economy and the high debt-to-GDP ratio of 135%, even though the debt crisis seems to belong to the past.

There are three main parties/alliances contesting the elections:

• Democratic Party (PD): The center-left government is currently in power with caretaker Prime Minister Paolo Gentiloni. The leader is former PM Matteo Renzi.
• Forza Italia: The center-right alliance that participates in the current government is led by former PM Silvio Berlusconi, which aims for a comeback despite his age (81) and convictions.
• 5-Star Movement: Anti-establishment left-wing party led by the young Luigi Di Maio. 

Hung parliament is not so bad, Berlusconi comeback possible

1- Hung parliament to Grand Coalition: The most likely outcome according to analysts is a hung parliament in which neither of these three blocs reaches an outright majority. In this case, the center-right and center-left parties may opt for a renewal of the Grand Coalition, again under Gentiloni. This would be the most favorable outcome for markets, as the stance would be pro-European and mostly pro-market. The euro would tick up.

Another grand coalition will not come instantly and may leave some uncertainty in the short run. Nevertheless, the current government has been comfortable for both parties, and they should be able to cobble up a coalition.

2a- Berlusconi is back: Another possible outcome is an outright majority for the center-right alliance, sending Berlusconi back to power from behind the scenes. If his party with the right-wing alliance, Forza Italia, wins more votes than his partners of The League, Antonio Tajani will lead the government. He is currently the Speaker of the European Parliament.

European leaders are not big fans of having Berlusconi behind the scenes,  but markets would probably cheer a center-right, pro-business government in Italy. The euro may rise even further on the immediate certainty of having a new government. 

2b - PM Salvini: Yet within the option of an outright majority for the right-wing alliance, there is a chance that the biggest party within the alliance is The League, formerly The Northern League (Lega Nord) that called for the breakup of Italy between north and south. The League leader, Matteo Salvini, is considered a populist and has bashed the euro in the past.

If they emerge as the largest party, Salvini may become PM and that would be seen as an adverse development. In this case, the euro may suffer in the immediate aftermath, probably until Salvini sends a oothing message to markets.

The other options have a low probability.

3 - Renzi returns: A win for the center-left PD would represent continuity and would be favorable for the markets, but the party is in decline. The EUR/USD could tick up.

4 - 5 Star-Movement wins: The worst option for the markets and the euro would be an outright majority of the 5-Star Movement. They may be anti-business and may trigger some instability within Europe even if they do not propose leaving the euro-zone. Yet also here, the chances are remote. In this scenario, the EUR/USD would fall sharply on this extreme scenario.

Conclusion - EUR/USD risks mostly do the downside

These two important political events have the potential to shake the Euro in the wake of the new week. Positive outcomes are mostly priced in, so a move depends on adverse surprises. In case of an SPD rejection, the Euro will likely suffer regardless of the Italian elections as this will be a bigger surprise in the largest country.

In case the SPD gives the green light, the risk is lower. The reaction may have to wait until the results in Italy are clear enough.

More: Italian elections have the potential to be EUR unfavorable