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It seems that regional politics would imply a weaker euro, the forecast for EURUSD is unchanged with a decline to 1.04 in Q1’end on regional political risks (greater in H1 due to the French elections) and optimism on Trump’s policies, followed by a near-10% strengthening later in the year on ECB tapering (Q2 1.06, Q3 1.08 and Q4 1.15).
Euro area politics continue to be in focus with a Le Pen Presidency in the French elections the main concern, for now, the casualty has been the bond market in conjunction with the FX markets. While French-German yield spreads have widened nearly 20bp YTD to a 3.5-year high, there remains little evidence of political risk priced into the currency with the TWI 0.5% stronger. A key development in the past month has been a decline in Fillon’s support in polls which has benefitted Macron on margin. There could be three distinctive scenarios out of this political turbulence.
Scenarios 1: An umbrella of scenarios perceived as benign, where Hamon and Melenchon do not present a unified radical left candidacy, the judiciary and public opinion pressure on Fillon abate and either 1) both Macron and Fillon qualify, or 2) either Le Pen or the left wing candidate gather less than 30% of the vote to face either Macron or Fillon.
Scenario 2: A scenario of moderate market stress with either Le Pen or a unified left candidate achieving a 30%+ score, vs either Macron or Fillon (or the “Republicans” candidate called in replacement).
Scenario 3: The acute market stress in a confrontation between Le Pen and a Hamon/Melenchon coalition. Regardless of the probabilities of occurrence of each scenario, we make simple arbitrary assumptions for each scenario in terms of market impact in order to rank the efficiency of vanilla EURUSD hedges:
Scenarios 1: Is associated with moderate relief in EURUSD spot (+2% to 1.08 back to year highs) and vols (down -1vol in the parallel shift). Some token risk premium would remain awaiting the result of the second round, but the risk of a Le Pen or leftist presidency would be perceived as low.
Scenario 2: EURUSD down 4% to 1.02, and vols up +2vols. A surprisingly strong momentum in favor of a populist candidate would spook investors, but the base view would remain that the mainstream candidate would prevail in the second round.
Scenario 3: EURUSD down 8% to 0.97, vols +4, after possibly larger overshoots. Significant portfolio outflows would be expected in such event.
