French election: Is the market too comfortable with a Macron win?

The second round of the French Presidential election will take place this Sunday, 7th May, the candidate who will win the keys to the Elysee Palace should be known by approx. 1900 BST, although the result won’t be confirmed until later, when all of the votes are counted.

The second round of the French Presidential election will take place this Sunday, 7th May, the candidate who will win the keys to the Elysee Palace should be known by approx. 1900 BST, although the result won’t be confirmed until later, when all of the votes are counted. The polls point to a landslide win for independent candidate Emmanuel Macron, and Oddschecker now puts his chances of winning at nearly 90%.

Why the polls could be right this time

Of course, polls have been wrong before, so some argue that Marine Le Pen could still win on Sunday, however, we feel confident that she will not be able to pull off a last-minute miracle win. When Donald Trump beat Hillary Clinton, the polls had tightened significantly in the lead up to the election, the same happened with Brexit. In contrast, Macron is still miles ahead of Le Pen, the latest polls have Macron winning nearly 60% of the vote, with Marine Le Pen on 40%. A 20 percentage point lead for Macron is much more than a margin of error, suggesting that the polls could have got it right this time.

We will continue to watch the polls closely, and unless we see a significant tightening in the next few days then we will assume Macron will have a comfortable victory on Sunday.  The question now is, what does a Macron Presidency mean for the financial markets, and, if Le Pen does pull off the impossible on Sunday, could she cause market panic?

President Macron and the markets:

  • A comfortable win for Macron could trigger a slight recovery in the euro, but positioning data suggests that victory for the independent candidate is already priced in. Short positions have fallen sharply since Macron won the first round, according to the latest CFTC data, and are now at their lowest level since mid-2014. Thus, it is hard to see how confirmation of victory for Macron can boost the euro in a meaningful way.
  • EUR/USD is close to the highs reached after Macron won the first round of the vote, and EUR/USD is trading close to 1.09 as we lead up to Sunday’s second round vote. While we expect the euro to remain resilient, we would only expect a 50-100 pip rally on the back of a Macron victory on Sunday. Our expectations are muted because of the 150 pip jump in the euro immediately after the result of the first round.
  • The options market is also sanguine about the outcome of this weekend’s vote, the 1-month risk reversal for EUR/USD had widened to its most extreme reading of 2017 before the first round vote, suggesting that there was a significant build-up of downside volatility premia in the euro heading into round one. This has reversed completely, as you can see in figure 1, which suggests that the political risk premium in the euro has been reduced, which could limit euro movement on the back of a comfortable win for Macron on Sunday.
  • The French and German yield spread has also fallen sharply since Macron won the first round of voting last month. It had peaked at 80 basis points but is now a mere 48 basis points, the lowest level since January.
  • The reduction in French bond yields is significant, as the French bond yield had a significant negative correlation with the Dax, the EUR and the Eurostoxx index in the lead up to the first round of the vote. So, as French bond yields rose, European equities and the euro tended to fall. However, the correlation between French bond yields and European stocks has shifted into insignificant territory post last month’s first round of voting, suggesting that the markets are being driven by factors other than French politics now that Macron is expected to cruise to victory on Sunday.

Overall, we see a win for Macron as having a limited market reaction, as the “good” market news of his victory has been mostly priced in. The biggest risk for the European markets could come from the National Assembly elections in June, where Macron will need his party members to win a significant number of seats to ensure that he can turn his political agenda into a reality. We will cover this in more detail closer to the time.

Figure 1: 

Source: City Index and Bloomberg

A surprise win for Le Pen:

Although we consider this a low probability event, if it does happen it could be high risk and cause a sharp drop in risky assets. Although Mme Le Pen has dampened her “Frexit” talk ahead of the second round of voting, we think that if she does become President then she would reignite her desire to take France out of the EU and to abandon the euro. This could spook the markets and cause a large leap in French bond yields. If this happens then we could see sharp falls in European equity indices and a large drop in EUR/USD, potentially back to the 1.0340 lows of the year so far.

A Marine Le Pen victory could have broader implications for the currency bloc, with the potential for a sharp rise in French bond yields to cause contagion elsewhere, particularly Europe’s weaker countries that also have elections coming up including Italy. This could trigger a more sustained global market panic and a significant rise in volatility.

Conclusion:

The market is expecting Macron to cruise to victory on Sunday. Although the polls have been catastrophically wrong in recent years, we think that Macron’s wide lead over Le Pen is more than a margin of error, and is probably a sign that he will be the next President of France.

We expect a limited reaction to a Macron victory, as price action since the first round of the vote suggests that his victory has already been priced in. This is particularly evident in the euro, while European equities have become less sensitive to French political risk post Macron’s victory in the first round. 


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