The euro looks set for considerable volatility after the elections in Bavaria saw support for the Christian Social Union (CSU) fall to its lowest levels since 1950, highlighting how the public mood is changing in Germany. The CSU won 85 seats which is 18 short of the required 103 to control the Bavarian Parliament. The CSU now looks to find support in the way of a coalition, with the Free Voters party which came third in the election with 27 seats. It has been reported that a deal could come as soon as Wednesday which could prove beneficial for the euro.

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German regional elections

However the result now causes political uncertainty in Germany, at a time when the grand coalition proved very difficult to re-establish after the last election. It is now the Social Democrats (SPD) who are considering breaking away from the coalition in a bid to reinvent itself as the party of opposition, after they too had a bad election night. Deputy leader Ralph Stegner has stated that “the durability of the grand coalition is wasting away. There is no good reason to cling to the grand coalition at any price. Simply carrying on is not an option.” The SPD Party has been falling in the polls and this strong commentary would suggest that they may withdraw their support. There is another election in two weeks’ time in Hesse in the west of Germany, and a poor outcome could put pressure on Angela Merkel to resign which would result in more uncertainty for the single currency.

Italian debt weighs heavy on euro

Italy put forward its draft 2019 budget to the EU yesterday for review by the EU commission. Italy are still seeking to cut taxes and increase Government spending after promises were made by the ruling Lega and Five Star parties, however this plan is at odds with EU rules. EU finance ministers will officially give their final recommendation on December 3rd, although considering the political escalation to date there are likely to be statements made in these coming weeks. The commission is expected to reject the plans initially, but will make recommendations for improvement with some sort of compromise the most likely outcome.

If Italy is unable to demonstrate that the level of debt held ($2.3 trillion) is manageable then the cost of borrowing could rise quickly in Italy. This could cause problems domestically and could also spill over to the wider EU economy which would be euro negative. A credit rating downgrade in the meantime is a distinct possibility which could come as soon as this month, this would also prove euro negative.

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