Election Aftermath: CDU/CSU Victory Sparks Coalition Negotiations and Fiscal Reforms
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Article Type
Insights
Topic
Opinion
Published
February 25, 2025
Read time
5 mins
Author
Luca Ferramosca, CFA
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Friedrich Merz’s CDU and the Bavarian sister party, CSU, have won the German elections, getting 28.6% of the votes. The far-right AfD came in as the second largest party with 20.8%, followed by the SPD (16.4%), Greens (11.6%) and The Left party (8.8%). As of now, it’s too premature to determine whether a two-party (CDU/CSU + SPD) or a three-party coalition government (CDU/CSU + SPD + Greens) will be formed.

 

The new German parliament is expected to remain fragmented, while a grand coalition between the CDU/CSU and SPD is the most likely outcome. This coalition could potentially unleash a long overdue fiscal response aimed at curing the country’s economic malaise. In fact, a key focus will be on the debt brake rule, which has garnered significant attention in the run-up to the elections and is especially important for the market. The debt brake (Schuldenbremse), approved in 2009, limits federal government borrowing to a ceiling calculated as the sum of 0.35% GDP and a ‘cyclical component’, minus financial transactions.

 

Negotiations to form the new coalition will take some time and achieving the required two-thirds representation in the parliament for constitutional amendments may be challenging without the support from the far-right AfD or The Left (who has explicitly opposed any increase in defense spending). Nonetheless, the political momentum and public consensus make the debt brake reform more feasible.

 

The upcoming grand coalition is likely to agree on investments in infrastructures and defense and could bring tax cuts for households and the manufacturing sector as well as some deregulation. While CDU has been a staunch defender of fiscal discipline, it has proposed significantly costly and ambitious programs.

 

Outcome offers little guidance

The market impact to the election results was relatively muted on Monday, with bund yields discounting already a fair amount of term premia from anticipated and long-needed fiscal expansion. Increased volatility was witnessed in German asset swap spreads, with 10-yr bund cheapening around 3 basis points vs swaps. The market’s perceived tail risk ahead of the elections was an AfD outperformance and FDP parliamentary entry which have both failed to materialize. This would have led to a marginal rally in duration. While the downside risk to the front-end EUR curve remains intact due to exogenous factors such as tariff developments, the German curve was dragged steeper by the belly and back-end. In the FX market, EUR/USD remained relatively stable throughout the session after briefly breaking out higher in the morning. While the likelihood of the currency pair dropping sub-parity has gradually reduced, the outcome of the German election is likely to offer little visibility on a domestic fiscal regime shift which would be considered positive for the euro in the short term.

 

A potential reform of the debt brake will certainly improve both local and eurozone-wide sentiment. However, with the forming coalition being led by fiscal hawks, the impact on country-level issuance will be limited. German asset swap spreads are likely to continue trading in a tightening range as the forward path for the German free float is upward, yet it is hard to argue for any decisive and meaningful increase in issuance. In fact, there is a chance that the German Finance Agency would accommodate any additional 2025 net borrowing via other flexible instruments such as repo transactions and increased bill issuance, rather than sharply rounding up coupon issuance. The ensuing impact on supply from a more fiscal easing stance will likely be felt only in 2026.

 

Other factors, such as macro, inflation, monetary policy will remain front and center in shaping the eurozone rates market in the coming months. Discussions over a potential Russia-Ukraine ceasefire have intensified over the past week, with possible implications for Europe, including increased EU defense spending, reconstruction efforts in Ukraine and the potential positive supply shock from a resumption of Russian gas flows to Europe. The implementation of reciprocal tariffs, as advanced by president Trump, will continue to weigh negatively on eurozone growth projections and broader sentiment. However, the outcome of the German election sets the stage for a more constructive local business sentiment.

 

Against this backdrop, European citizens will continue to grapple with political headlines and defer their hopes to a brittle political establishment for a more decisive and concrete plan to restore Europe’s competitive landscape. Strategic funding of pro-growth initiatives will be essential in shaping the continent’s future, as it continues to suffer from an existential crisis and ongoing economic stagnation.

Disclosures

Author

Luca Ferramosca
Portfolio Manager

Luca Ferramosca, CFA, is a portfolio manager with a focus on sovereigns. Prior to his current role, he worked as an institutional sales analyst at Aegon AM. 

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