Angela Merkel seems almost assured of a fourth term as Germany's chancellor Sept. 24, but the identity of those who will share her eventual coalition is unclear, raising questions over policies ranging from tax to the future of the EU.
Merkel's Christian Democratic Union, or CDU, had a lead of 14 percentage points over its current partner in government, the Social Democratic Party, or SPD, as of Sept. 11, according to a poll of polls by Pollytix Strategic Research.
At the same time growing support for the liberal, pro-business Free Democratic Party, or FDP, and the left-leaning Greens, together with an opinion held by some in the SPD that they need a spell outside government to rebuild their popularity, has raised the possibility that the "Grand Coalition" might give way to a deal between the CDU and a different junior partner.
Ricardo Garcia, economist at UBS Wealth Management, still rates the chances of another CDU/SPD government at 60%, but said political uncertainty had "increased markedly."
A return to government for the FDP — which governed in coalition with the CDU in Merkel's second term — would mark a relative sea change in German politics and potentially have profound consequences for the rest of the eurozone.
To Merkel, having the FDP as junior partner again could be an attractive option. Critics have blamed her own party's shift to the left in coalition with the SPD for leaving a vacuum on the right, thus breathing life into the anti-immigration Alternative für Deutschland, known as AfD, which is now heading to become the first right-wing nationalist party to win seats in the Bundestag for decades.
However, of the mainstream parties, the FDP's policy stance is the most removed from the broad consensus that has taken hold at the top of German politics under Merkel's Grand Coalition, and it takes a much harder line on the eurozone. The party has called for a new mechanism to allow orderly exits from the single currency, the phasing out of EU bailout fund the European Stability Mechanism and an end to the European Central Bank's low interest rate policy.
That puts it at odds with even Merkel's own cautious brand of eurozone reform.
"Merkel would probably be willing to pay a price, such as a concession on tax, for the FDP to compromise on the European issue," Garcia told S&P Global Market Intelligence.
Under leader Christian Lindner, the FDP has called for income tax cuts and further measures to reduce public debt, despite Germany's balanced budget already being a rarity among peers.
Both the CDU and the SPD have also promised tax cuts.
Merkel's party want to raise the 42% upper tax rate threshold to €60,000 from €56,000, while Martin Schulz's SPD would do the same, although in addition to slashing the threshold on the top 45% top rate to €76,200 from more than €250,000. The FDP also vehemently opposes introducing a financial transaction tax, which is supported by the CDU, the SPD and the Greens.
Some polls suggested almost half of German voters remained undecided at the beginning of September, but Garcia has detected a crucial shift in recent polling.
"The underlying trend is a shift towards the right, with the CDU and the SPD losing some voting intentions [in the polls] to the FDP and the AfD," he told S&P Global Market Intelligence.
"This trend is kicking in now people are making up their minds. The SPD has lost support in September, which is significant. The question now is whether the increasing support for the FDP continues, because if it does that could put a CDU-FDP coalition on above 50% next week."
There has been talk of a "Jamaica Coalition" involving both the FDP and the Greens, but the ideological gulf between the two smaller parties on issues such as tax, immigration and foreign policy may render it unworkable, according to Anatoli Annenkov, a senior European economist at Société Générale. In addition, the Greens have never worked in coalition with the CDU at the federal level.
"The temptation for the CDU to again work with an increasingly popular FDP should be strong, but differences over Europe may in the end push the CDU towards the SPD and the Greens," he said in a Sept. 11 note to clients.
"The coalition negotiations may thus take longer than usual."
One of the most critical negotiations will be over the key post of finance minister, which analysts believe both the SPD and FDP would try to claim in any coalition agreement with the CDU.
German media has reported that Merkel is willing to pay a "high political price" to keep Wolfgang Schäuble, the current finance minister who has gained a reputation as a scourge of periphery economies, where he was seen as the architect of post-crisis austerity policies.
The presidencies of the ECB, European Commission and European Council are all due to be vacated in late 2019; the sense of many commentators in Germany is that if Schäuble were to depart the finance ministry, it would be with the knowledge that he was earmarked for such a top European role. But equally Merkel could charge a high price from any potential coalition partner for him to depart.
In 2013, it took some two and a half months for the CDU-SPD coalition to take shape. Despite negotiations potentially being even trickier this time around, markets are unlikely to oscillate as they did around the recent Dutch and French elections, where populist parties were given more than an outside chance of taking power.
"For the bond markets it is likely to be pretty much a non-event, since Bund issuance will stay flat given a CDU-led coalition with either the FDP or the SPD," said one head of bond syndicate at a European investment bank, who asked not to be named on a political issue.
"Longer-term there could be an impact on periphery bond spreads to Bunds, as the FDP would probably force a harder line on Europe than the SPD."