The Three Things You Should Know About This Weekend's Big German Elections

On Sunday, Germany holds national elections.

German Chancellor Angela Merkel is widely expected to retain her place at the head of the German government, and financial markets don't seem too worried.

However, even though Merkel's job is likely secure, there's a good chance that the elections will result in a different ruling coalition, which could present problems for Germany and for the eurozone.

Merkel's current center-right coalition consists of her own Christian Democratic Union (CDU) party, its Bavarian sister party the Christian Social Union (CSU), and the Free Democratic Party (FDP).

Though CDU/CSU remains atop the polls, the FDP's share of the vote has been on the wane, casting doubt on a continuation of the current government. If CDU/CSU and FDP combined are unable to gain a majority in parliament, Merkel's party may be forced into a grand coalition with the center-left Social Democratic Party (SDP).

Here are the three things you need to know.

1. How the election will impact the eurozone

Société Générale economist Anatoli Annenkov expects that if the current CDU/CSU coalition with FDP remains in power, Germany will be unlikely to budge from its current approach toward the eurozone.

"As the current government has already shown flexibility on Europe - accepting some trade-offs of short-term austerity for long-term structural reform - we see no change in its determination to pursue reform in the crisis-struck countries, nor in its willingness to accept any form of debt mutualisation/forgiveness," says Annenkov.

Morgan Stanley economist Elga Bartsch believes there will be "no post-election shift in [the] German stance on euro crisis," regardless of whether the composition of the government changes or not.

"Many market participants and political counterparties seem to believe that Germany's stance on the euro crisis will shift materially after the election," writes Bartsch in a note to clients. "In our view, a major shift on key issues, such as debt relief, joint issuance, or direct bank recaps, is unlikely given public opinion and constitutional constraints in Germany. In fact, we are concerned that a narrow majority for the centre-right may reinforce a relatively tough stance on additional aid."

2. What the election will change in Germany

"In our view, the election result will have greater implications for domestic than European policy," wrote BofA Merrill Lynch economist Laurence Boone in a report published earlier this month.

"Euro-area policies have not been a major issue in the campaign so far," said Boone. "In our view, the main challenge facing the new government will remain the implementation of 'Energiewende' (energy transition). This could significantly impair Germany's competitiveness and, absenting as yet undebated structural reforms, poses a risk to Germany's recent economic miracle."

SocGen's Annenkov asserts that "Germany will be less stable after the election."

"With significant economic challenges ahead, there is a risk of greater political instability in Germany over the coming parliamentary term," says Annenkov. "With significant economic challenges ahead, there is a risk of greater political instability in Germany over the coming parliamentary term. This in turn risks leaving policy uncertainty high in Europe; thereby further negatively affecting German investment and economic activity."

The SocGen economist says it would be worse if Merkel's CDU/CSU is forced into a grand coalition with SPD.

"A strong win for the CDU/CSU and FDP should ultimately result in more of the same. Domestically, the government would likely focus on increasing labour supply, reforming energy policy and improving investment conditions in Germany, while we only see limited progress with liberalising service markets," says Annenkov. "In contrast, the opposition is likely to pursue policies that are suboptimal for growth, relying excessively on tax increases to fund social reforms and public investment."

3. What it all means for markets

The euro is probably the first place investors will be watching for the market's reaction to the outcome of the election.

"Re-election of the current coalition would not have a meaningful impact on equity markets but would likely be negative for the [euro]," says Morgan Stanley's Bartsch. "A coalition between CDU/CSU and either Greens or the SPD would be bullish for the [euro]. In rates space, we would expect some spread widening, while outright price action will be dominated by the Fed's decisions."

BofA Merrill Lynch interest rate strategist Ralf Preusser doesn't expect to see much market reaction, regardless of what happens Sunday.

"Beyond a short-term, initial reaction we do not see the German election as a major catalyst for markets one way or the other," says Preusser. Knee-jerk reactions could lead to underperformance of Bunds and out-performance of the periphery on election results that suggest a grand coalition is the most likely. A return of the current government would arguably be neutral for Bunds and potentially negative for the periphery, especially if the [Alternative für Deutschland] does well."