French election preview: Why a “shock” win could be good for the euro

The first round of the French Presidential election takes place on Sunday 23rd April, with the exit polls expected late that night before the final confirmation of the results sometime early on Monday morning. The results from Sunday's vote will determine which two candidates will be included in the second round of voting on May 7th.

Four-way race predicted

This has been an interesting election cycle with the pollsters calling it a four way race at this late stage. However, this has meant that the two frontrunners to win the first round: Emmanuel Macron and Far Right candidate Marine Le Pen, have seen their chances slip, which has reinvigorated the campaigns of centrist Francois Fillon and Far Left candidate Jean-Luc Melenchon.

The latest polls (18th April) from Presitrack have Macron polling 23% of the vote in the first round, Marine Le Pen at 22%, Fillon at 20% and Melenchon at 19%, according to Presitrack, a daily online French pollster. This is still well within the margin of error, so the prospect of Far Left and Far Right second round run-off in May cannot be ruled out.

Is the market too optimistic on Le Pen's chances?

What has been interesting about this Presidential race has been that most of the polls have agreed that Macron will win both the first and second round of voting, however, there is a lot of divergence between bookmakers on the implicit chances of Fillon and Le Pen winning the first round. For example, the French bookmakers have seen French traders betting on Fillon winning rather than Le Pen, whereas the UK and US bookmakers' see Le Pen beating Fillon. If you think that French traders, who are closer to the election, are a trustworthy source, then maybe the market is too optimistic on Le Pen's chances?

It is worth digging a bit deeper into the data to figure out whether the French election could throw a Brexit or Trump-style grenade into the financial markets. Although Macron and Le Pen are still expected to win the first round vote, a third of the electorate also told the pollsters that they could still change their minds. Added to this, Macron's supporters tend to waver the most. This is why it is premature to rule out a place in the second round for Francois Fillon, the centre-right candidate who was considered washed up after a controversy around him paying his family for "fake jobs". If this election is as wide open as the polls suggest, then Fillon, with his solid block of conservative voters, could still be in the game.

Potential market reactions

The prospect of Fillon making into the second round run-off seems to be reflected in financial markets with less than 5-days to go before voting begins. The French-German yield spread has stabilised at around 73 basis points, although this is the highest level since 2012, it is well below the 2011 high for the French – German spread which reached 130 basis points. We also noted last week that correlations between French bond yields and European asset prices have started to rise as we lead up to the first round of voting. As we get even closer to polling day these correlations have risen further: at the start of April the Cac 40 index had basically no correlation with the French 10-year bond yield, however, in the last 10 days this correlation has risen to close to 60%. The correlation between the French bond yield and EUR/USD has also risen to -53%, so when the bond yield rises the euro tends to fall half of the time, and vice versa. We expect these correlations to be maintained and even extended as European asset prices get more sensitive to French election risk the closer we get to polling day.

What would be a euro positive and negative result?

In recent elections market performance has been a tricky thing to predict, for example, not many people thought that a win for Donald Trump would unleash a record-breaking global stock market rally, but it did. However, we think that the risk to the euro from the outcome of the French Presidential election means that Sunday's result could have a major impact on the euro. Below we try and break down the three most likely outcomes from the first round of the election and determine the potential impact on the single currency and other European asset prices.

1, Macron and Le Pen:

Although the data suggests that Macron will still win the second round, the fact that Le Pen is in with a chance could cause the euro to wobble, French bond yields to rise and a decline in the Cac and Eurostoxx index. The magnitude of the euro's decline could depend on the margin of victory for Macron, if his victory over Le Pen is tight, then the market may start to price in the prospect of a Le Pen win in the second round, which could trigger a sharper euro sell off, initially back towards the 1.0340 lows from the start of the year.

2, Macron and Melenchon:

Melenchon is a Far Left candidate, so we could see a sell-off in French stocks, as his economic policies may not be considered positive for corporate France. However, as we get closer to voting day Melenchon has softened his rhetoric towards France's membership of the euro, which could limit euro downside on the back of this election result. But again, it would all depend on the margin of Macron's win, if he only scrapes past Melenchon then we would expect a deeper decline for the Cac and the euro.

3, Macron and Fillon:

This result is still a possibility as we edge closer to Election Day, and would be the most market friendly in our view. A win for Macron with Fillon in second place would restore faith in centrist politics, which has been eroded ever since last year's Brexit vote in the UK and Trump's triumph in the US Presidential election. The eradication of the Far Left and the Far Right candidates in the first round would likely see a collective sigh of relief that it is politics as usual in France. This combination for the second round could unleash a surge in the Cac, a sharp drop in French bond yields and a decent move higher in EUR/USD back towards 1.10, we could also see EUR/GBP recover back towards 0.8570 – a cluster of key resistance levels.

Overall, there is a chance that the market has been wrong-footed once again by the polls, and Le Pen is not guaranteed a spot in the second round. If we are correct, then the political premium that has kept the euro range bound in recent months could evaporate, allowing the single currency to stage a decent rally on the back of a victory for the two moderate, pro EU candidates on Sunday night.

A last word on the FX options market

The FX options market was fairly accurate at predicting the market volatility that accompanied the Brexit vote in the UK and Trump's victory in the US, thus it is worth looking at EUR/USD risk reversals ahead of the French election. What we tend to see is the skew for puts (downside protection for a currency) tends to fluctuate wildly in the days ahead of the vote, however, that has not been the case this time, with demand for EUR/USD puts that expire after the May vote remaining fairly flat in recent days, and actually falling, suggesting that options traders' are fairly sanguine at the prospect of the French election result. This suggests that the FX market, which has been good at predicting market volatility in recent elections, is becoming less concerned about a market-negative outcome from the French election, which may suggest that they have a degree of confidence that Le Pen won't make it to the second round on Sunday, and it could be a more euro-friendly Macron/ Fillon outcome. We shall have to see if the options market is correct.

Market idea

From a technical perspective, EUR/USD is facing a key resistance test in the short term. This pair is testing the 61.8% retracement of the mid-March high through to the April 10th low at 1.0777. If it can break through this level on the back of expectations that the more extreme candidates in the French election won't get enough votes to move through to the second round, then we could see a move back to 1.0850 first and then the 1.0900 high from mid-March.

EURUSD

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