Strategists at the world's largest investment bank have callibrated the potential financial market impact of a Marine Le Pen win in France's upcoming Presidential elections.
For the Euro, the impact will be notable.
JP Morgan still believe there is a very small probability of Le Pen winning and her party holding control of parliament which will be required to attempt to take France out of the Eurozone and then European Union.
The chance is set at 3%. Yet, markets are not taking any chances.
"The possibility of a right wing win in France is raising fears in Europe, as highlighted by the rising yields on French treasuries. With the spread between French and German yields rising to the highest level in four years, there is clearly a significant degree of anxiety that is creeping into the market mindset," says Joshua Mahony, Market Analyst at IG.
There is a sense that a disproportionate risk exists given the surprises metted out by the UK and US electorate in 2016.
Although the French have something of a tradition in tactically voting against the Front Nacional the risks remain that a change in the global social mood may also infect the French and lead to a majority voting for a reactionary return to protectionism and patriotism.
The loss of credibility of Francios Fillion over a tax scandal has also increased the risk of a Le Pen win.
Fillion at first appeared the most likely rival to Marine Le Pen’s in the second round of the contest and according to pollsters was the rival that was likely to beat her by the widest margin.
However, since the tax scandal he appears to have lost ground and Le Pen’s rival could be any one of several candidates. As noted here, if that rival candidate happens to be from the left of French politics then the prospect for a Le Pen win becomes all the more real.
A Likely Market Response to a Le Pen Win
In the event of a Le Pen victory the general response from bond markets is likely to be a spike in French government bond yields to reflect fears of a devaluation.
Le Pen is expected to seek to replace the euro with the Franc, which will lead to probable large relative devaluation of the Franc and major problems in the short-term for the French economy.
JP Morgan contrast this to the reaction of German bunds which would be expected to rise in value after a Le Pen win, as capital flight to safety and the Euro supports safe-haven flows.
French bond yields will ‘spike’ because of the falling value of French bonds after a Le Pen victory.
Yield is a calculation of the gross return for a bondholder to expect and thus includes both the ‘coupon’ or interest repayments and the principle which is repaid at the end of the term.
Investors who pay less than the original value of the bond – for example, 95 euros instead of the original 100 - will gain an extra 5 euros at the end of the term when the principal is repaid.
Add this to the repayments which remain the same and the total return increases, thus increasing the yield. This explains why the yield rises when the bond price falls.
This has led JP Morgan to recommend bond traders buying the spread between the French over German bond yields, as it would be set to widen the most.
An all-out Le Pen victory in both the Presidential and parliamentary elections is not the only outcome J P Morgan consider.
Other alternatives include a Le Pen victory with an unsympathetic parliament (25% probability) – or “cohabitation” as they call it - and a Le Pen failure and mainstream candidate winning instead (72% probability).
The table below shows the various outcomes and the forecast response to these by various government bonds.
Foreign Exchange Impact
The impact on EUR/USD of a Le Pen victory is expected to be considerable.
Commenting in their current forecasts, J P Morgan’s rate strategists argue that they do not reflect the recent increase in French political risk.
“The JPM EUR/USD forecast from the year-ahead outlook published last November only showed modest depreciation this spring in anticipation of these event risks (Q1 target of 1.04), then stability in Q2 assuming France delivered a mainstream government (1.06 target), and appreciation in Q3 (1.08) and Q4 (1.15) ahead of definitive ECB tapering,” says JP Morgan’s Fabio Bassi.
They, therefore, see a move below 1.04 at least, in the event of a Le Pen win.
"Euro and oil have decent downside on a Le Pen victory: euro could fall about 10 cents to about $0.98 over a few weeks and oil could decline by 5-10 percent," says Bassi.
If anything, EUR/USD is also currently overvalued, not only reinforcing the idea that political risk has not been factored in but also partly due to Trump jawboning the Dollar down too.
Evaluating the Impact on the Euro – a Lesson From Greece
To help model the impact on EUR/USD JP Morgan use the Greek elections in 2012 which saw the victory of the anti-Euro Syriza party as a template.
“In the month after Greece’s inconclusive elections in May 2012, the euro fell 6%.”
However, they see certain distinguishing characteristic which make the French case different from the Greek case.
Unlike Greece a French exit from the Eurozone would probably spell the end of the European project and very possibly the Euro.
“Many factors distinguished Greek events in 2012 from subsequent ones in the region. One such factor was that some European polls never entailed material EU exit risk to those who thought through mechanics of euro exit.”
In addition, there was little exposure to Greek assets when Syriza won as most Eurozone banks had shifted their holdings of Greek debt off their balance sheet and into the ECB’s emergency fund.
In the event of a Le Pen victory in France, however, the potential for exposure would be enormous, as not only is the French economy 10x bigger but there has been no writing down of debt by its creditors or time to prepare.
JP Morgan, therefore, see several reasons to expect a Le Pen Presidency to generate market moves probably exceeding those triggered by Greece in 2012.
How to Trade Le Pen
The only straight spot cash currency trade advocated by JP Morgan to take advantage of the volatility of Le Pen win is to trade EUR/CHF.
The combination of deep losses for the Euro in the event of such an outcome, and gains for the safe haven Swiss Franc (CHF) simultaneously are expected to provide the greatest potential for volatility and profit from the subsequent move.
“Given the cross-currents from Trump’s policies, we have avoided hedging European political risk so far through short EUR/USD cash, and opted instead since late 2016 to sell EUR/CHF cash and own 1-yr EUR/USD straddles,” said J P Morgan’s Bassi.
They advocate trading EUR/USD using an option straddle.
This involves buying both a put and a call option on EUR/USD and placing the put at the top of a range and the call at the bottom.
The straddle will profit the most if the exchange rate remains inside the range as then both options are in the money.
In the event of a highly volatile move it can still profit as one of the options is stopped out at the range highs or lows whilst the other goes on to make a profit, the more far-reaching the move the greater the gains.