LONDON, Aug 25 (Reuters) - A momentous German election marking the end of Angela Merkel's 16 years as chancellor is less than a month away and with no clear outcome in sight, markets may start to pay attention.
Germany's centre-left Social Democrats (SPD) have taken a poll lead over Merkel's conservative Christian Democrats (CDU) for the first time in 15 years this week.
Uncertainty has also crept up as the Greens, previously tipped to be the leading party in a coalition with the CDU/CSU bloc, ceded ground in the polls, while approval ratings for CDU leader Armin Laschet have plunged. read more
The election could yield a "Jamaica" coalition of the CDU/CSU, Greens, and the business-friendly Free Democrats (FDP). Or Europe's largest economy could get a "traffic light" coalition, led by Finance Minister Olaf Scholz's SPD, with the left-leaning Greens and the FDP as junior partners.
The terms reflect the symbolic colours of the parties - black for CDU/CSU, yellow for FDP, green for the Greens and red for SPD.
German elections rarely make market waves but the range of possible outcomes is wider than in the past, said Berenberg chief economist Holger Schmieding, who sees the shift towards the SPD as "modestly negative for markets" because it raises the risk of protracted uncertainty.
"For the first time this year, polls suggest that a two-way coalition between the CDU/CSU and the Greens would be narrowly short of a majority of seat," Schmieding said.
Here are some potential market implications:
1) AUSTERITY IS HISTORY?
The pandemic forced Germany to reverse long-observed fiscal restraint and focus initially had been on whether the Greens could make that change permanent as they had led the polls. The party pledges spending increases and reform to a debt brake which limits new federal borrowing to just 0.35% of GDP read more .
"In general, across all parties, maybe with the exception of the Liberals, there is a tendency to give the government a little bit more (fiscal) leeway," said Joern Wasmund, global head of fixed income at DWS.
Structurally higher spending and borrowing would lift bond yields, and by potentially improving economic growth prospects, also the euro. But the CDU or the FDP, which will almost certainly join any coalition, want to reinstate the debt brake.
"My bet is there is a chance of 70% that the CDU-CSU will be part of the next German coalition, which means we won't see a major change in terms of fiscal spending," said Christopher Dembik, head of macro analysis at Saxo Bank.
Ditching the constitutionally-enshrined debt brake also becomes unlikely, as that requires a two-thirds parliamentary majority.
But yields will not necessarily fall.
Some in the CDU/CSU are open to additional spending with the debt brake. That could generate some 100 billion euros ($117.54 billion) of infrastructure and environmental spending - 3% of 2019 GDP - over the next four years, ING's head of global macro Carsten Brzeski says.
2) REGULATION RISKS
A leftist Greens/SPD/Left Party coalition would raise the risk of tighter regulation to 20% from 15%, Berenberg's Schmieding estimates.
"Whereas tighter regulations of labour, service and housing markets would not have a major impact on the short-term business cycle, they could turn into a serious drag on German trend growth over time. This is the tail risk to watch."
Goldman Sachs analysts reckon a left-wing coalition could lift Bund yields about 10 basis points .
3/ CLOSING THE GAP
A coalition including the Greens and the SPD may narrow the spread between German borrowing costs and those of weaker euro zone states, given these parties' support for further European integration.
The FDP and the CDU meanwhile oppose a euro zone fiscal union and want a return to stricter EU budget rules.
Wasmund of DWS said however that none of the likely coalitions would bring about radical change.
"Particularly, the commitment towards the European Union will stay as it is," he added.
4/ ALL GREEN
Climate policy is a priority for all the parties but they differ in the way to achieve the goals, said Barbara Boettcher, head of European policy research at Deutsche Bank.
"The CDU and FDP put the emphasis on market instruments and technology driven solutions whereas the Greens prefer more regulation," Boettcher said.
The Greens favour hiking emissions taxes, cutting carbon emissions by 70% and targeting 100% renewable energy by 2030.
Wind and solar power companies should benefit alongside the auto sector, which is trying to challenge electric vehicle leader Tesla.
The Greens and FDP call for a tougher approach towards China and Russia, and there are signs the stance of CDU chancellor candidate Laschet has moved closer to theirs.
Laschet has described China as a rival and recently said Germany could stop gas flowing through the Nord Stream 2 pipeline from Russia if Moscow breaks arrangement terms or uses it to pressure Ukraine. read more
"This move will make negotiations on foreign policy easier in a potential Jamaica coalition," Eurasia Group's Naz Masraff said.
($1 = 0.8508 euros)
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