Euro hits fresh seven-week lows as German political uncertainty offsets risk-on mood

The Euro (EUR) is failing to draw any support from the moderate risk appetite triggered by the recent pullback in Oil prices and extends losses against the US Dollar (USD) on Tuesday, hitting fresh seven-week lows below 1.1450. The growing political uncertainty in Germany, after the defeat of Chancellor Friedrich Merz’s CDU in last weekend’s state elections, has posed a fresh source of weakness for the common currency this week.

Merz vowed to remain in power until the economic reforms planned by his cabinet have been implemented, but the severe defeat in the Mecklenburg-Vorpommern elections, where the CDU failed to reach the 5% necessary to enter the parliament for the first time in postwar Germany has raised serious questions about his support.

But beyond that, Merz's weakness undermines confidence in the fate of the Eurozone’s EUR 2 trillion budget proposal that includes a significant boost to the bloc's defence program, especially if the pro-Kremlin Allianz fur Deutschland (AfD) increases its power in the national parliament. A report by the Financial Times citing German officials involved in the talks affirms that this weekend’s elections have forced the EU to reassess what it could achieve in the coming months.

Concerns about France's debt add pressure on the Euro

Beyond that, a minor rating agency has downgraded France’s government debt, which has reached its highest level since 1978, amid bond market turmoil. This has raised the alarm about more relevant downgrades, as the chances of any significant fiscal tightening being implemented are remote, which is adding pressure on the Euro.

In the calendar on Tuesday, the main event will be European Central Bank (ECB) president Christine Lagarde’s speech at a conference organised by the Ukrainian and Polish central banks. due later in the day. The ECB hiked its benchmark interest rate for the second time this year and hinted at further tightening ahead if inflationary pressures remain high. Lagarde is expected to stick to that message on her public appearances. 

The US Dollar, on the other hand, is "deriving support from the sharp ongoing adjustment higher in US yields," according to analysts at MUFG/BTMU who observe that "the 2-year US Treasury bond yield has already increased by around 55bps since late last month as market participants have moved to price in a more extended Fed rate hike cycle." In their view, "the US rate market is expecting the Fed to deliver three more hikes in the year ahead," a profile that has been "supported by hawkish comments yesterday from regional Fed presidents, although neither is a voting member this year."