Why Spain not Germany could be the biggest risk for the euro

The rise of the Far Right AfD party at last weekend’s German election has grabbed the headlines, but as we said in our earlier note, Merkel remains as leader and the Far Right will not have power even if they have won a seats in the Bundestag. The market reaction is still mild, the Dax has rebounded after earlier gapping lower, while the euro remains weaker but EUR/USD is still holding on above last week’s low of 1.1862.

Populism rocks Germany’s markets more than France

The populist risk is still alive and well in Europe, as Germany’s election result makes clear, however the contrasting market reactions to the French and German election results is quite puzzling. Marine Le Pen, the leader of the Far Right in France, won a third of the French vote, while the AfD won 13% of the German vote, yet the Cac 40 surged nearly 10% after it became clear that Le Pen would not be able to win the French Presidency, this is in contrast to the muted market reaction to Merkel’s win in Germany. The logic behind this muted reaction is possibly to do with the huge rise in the euro this year, and the surprising decline in support for Angela Merkel is a perfect excuse to sell the euro at this elevated level.

Spain, and why referendums tend to be bad news for a currency

But, even if we see a Merkel-inspired dip in the single currency, we still expect it to be relatively muted, with a move back to $1.1650 – the mid-August low- a potential possibility to the downside. However, the bigger risk to the euro is unlikely to come from Germany, but instead could come from Spain where the Catalan region is planning to hold an illegal referendum on independence on 1^st October. The referendum has been deemed illegal by the central Spanish authorities, yet this has seemingly emboldened the separatist supporters, who are vowing to distribute 1 million ballots ahead of Sunday’s vote.

The risks of the Catalonia vote include:  

• If Catalonia votes for independence, even if the vote is deemed illegal, then it could put pressure on Madrid to allow the people of the region to have a legal vote, which could increase the chance of a break up of Spain.
• It could also have ramifications for the EU, would an independent Catalonia be allowed to join? Would it spur other nations to seek independence, not only from other countries’ but also from the EU?
• Overall, referendums in recent years have not been good news for a currency.
• Back in 2014, when Scotland held its unsuccessful independence referendum, the pound dropped 6% from July to September, before bouncing 2% when the referendum failed, then it resumed its downtrend.
• The pound generally had a good year in 2014, however it was weakest vs. the USD and NZD – a safe haven and a high yielder.
• Thus, if the Catalonia referendum goes ahead we expect this to be a disruptive event for the euro, with the potential for a sharp decline of up to 5% initially in the single currency if the separatists win.

This vote has also triggered an increase in Spain’s yield spread with German bond yields, as you can see in the chart below. In the past, an increase in peripheral yield spreads has spurred higher volatility in European share prices and in the euro. Although the Spanish- German yield spread is nominally low, if it continues to move higher then we could see it become a risk factor for European asset prices in the coming days.

Chart 1: 

Source: City Index and Bloomberg