A crucial German vote this Sunday is seen as the key near-term driver for euro/dollar

Key Points
  • Germany's SPD party is set to vote on a grand coalition with Merkel's center-right bloc
  • A fall in the euro is predicted if party delegates reject the deal
  • The common currency is currently at three-year highs versus the U.S. dollar
SPD leader Martin Schulz (L) and Chancellor Angela Merkel
Michele Tantussi | Getty Images

A crucial vote in Germany on Sunday has the potential to derail stability in Europe and send the euro tumbling.

The continent's largest economy has been without a formal government for four months with long-term chancellor Angela Merkel unable to secure a ruling coalition.

Last week, there appeared to be a breakthrough when it was announced that the hierarchy of the center-left Social Democrat Party (SPD) had agreed to a preliminary "grand coalition" with Merkel's center-right Christian Democratic Union (CDU) party.

In Bonn on Sunday, the SPD will ask its 600 delegates whether the party should begin full coalition talks. If that passes, the next step would be a postal vote for the SPD's 450,000 members.

The party's former leader, Sigmar Gabriel, who now acts as Germany's foreign minister, reportedly said last week that many around the world want a deal to be struck.

"It is no exaggeration. This coming Sunday it is not only Europe that is looking spellbound at the SPD party conference, but many people far further afield. The world will be watching Bonn on Sunday," he said.

The euro has enjoyed a stellar run of late, rising almost 4 percent versus the dollar over the last three months. It currently sits at around $1.22, marking a three-year high.

That run, while aided in no small part by dollar weakness, has been seen as a reflection of thumping euro zone data and relative stability among EU members.

Ulrich Leuchtmann, head of FX and EM Research at Commerzbank, said Friday that Sunday's decision has the potential to move the euro in either direction.

"Rejection threatens to lead to either a minority government in Berlin or to new elections. Both are not good for the euro simply because they would create uncertainty," he said via email.

"More importantly, however, the GroKo (grand coalition) would probably be euro-positive because this constellation could represent the greatest degree of Germany's support for the French president's European initiative among all conceivable political constellations in Berlin."

Leuchtmann said he could not forecast a result but that SPD delegates are normally "well-behaved party soldiers" who follow the leadership.

In a note Thursday, Morgan Stanley's European FX team wrote that Sunday's vote is the "key potential near-term risk" for unwinding the recent upward run for the euro.

It said a rejection of the deal could see the euro slip back down towards $1.17. Assuming a vote to pursue coalition talks is achieved, Morgan Stanley calls upside resistance at $1.23.

Martin Schulz, leader of Germany's SPD party
Sean Gallup | Getty Images

Martin Schulz, SPD leader and former European parliament president, has been traversing Germany in recent days to shore up support among party delegates.

His prospects of securing an SPD vote suffered a setback Tuesday when the party's Berlin branch voted to reject the talks and called on other delegates to reject any deal with Merkel.

A major split over a coalition also exists within the Social Democrats between its elders in the leadership and the party's youth wing.

The Jusos (young socialists) have pushed the slogan "NoGroKo," arguing that forming another coalition with Merkel's center-right CDU would be a sell-out of the party's values.

The head of Jusos is a 28-year-old politics student called Kevin Kuhnert, whose rising popularity is seen as a real threat to Merkel's ambition to rule again.

He wants the SPD to break free of its cooperation with the CDU or the party's future will be put at risk.

"The renewal of the SPD will happen outside a grand coalition or it won't happen at all," he said