How The Euro Will React After The First French Results Come Out
With the French voting stations open until 7pm, and the first exit polls due just after 8pm although the French media is authorized to report preliminary results (these are not exit polls, but numbers based on processed ballots) historically an accurate indicator, here is a simple matrix predicting how the Euro will respond once the results start trickling in, together with event probabilities, according Citi:
EURUSD (%) outcomes from French Election Round 1 (joint probability of outcome in parenthesis)
In addition to the broader Euro reaction, here are some further thoughts on the rest of the FX board from Citi’s Ran Ren, Josh O’Byrne, Todd Elmer, Richard Cochinos
Follow through on Extremes, EURUSD Expected Value (+0.67%)
There are six possible paths for two candidates to advance to the second round. Basically it’s a 4×4 grid with payoffs. Round 2 is a 2X2 grid. In other words the French elections it’s a two-step game with 18 possible payoffs, and a time lag of two weeks in-between node 1 & node 2.
For risk into Round 1, we think it makes most sense to bound the extreme outcomes (most market positive, most market negative), and treat the others as convex combinations.
Of those six paths, the ones that have the largest tail where we would expect further follow through is LePen/Melenchon (EUR-), or Macron/Fillon (EUR+). It’s only with these extreme outcomes would we recommend clients follow through on the initial price action. Outside of those outcomes, volatility should die down within a few hours.
We calculate the Expected Value for EURUSD on the day as +0.67%. We take the betting markets as indicative of the most likely outcome. The conditional probabilities are in parenthesis in the table above. This gives an expected value for EURUSD of +0.67% or EURUSD 1.08 over round 1 (based on a current spot of 1.073).
What are the spillovers? How does G10 respond?
Broader ripples from the French vote are more likely to come from the impact on risk appetite and volatility than any channel of expected policy shifts. While a Le Pen victory might threaten EMU stability, there would remain a great deal of uncertainty on timing and shape of follow through on campaign promises. The same is true of a surprisingly good result for Melenchon, since there is uncertainty the degree to which his proposed market ‘unfriendly’ measures would come to fruition and get support after the legislative elections. As such, the short-term impact is how much political uncertainty (both ahead of and beyond the second round vote) serves to constrain risk appetite.
The dollar should benefit from any surge in risk aversion, so it looks likely to be most sensitive to either a result which puts Le Pen in surprisingly firm stead in the run-up to the second round or one which pits Le Pen vs. Melenchon. The fact that investors do not appear to be running much exposure into the election may be a mitigating force for moves since it means there is less vulnerability associated with position paring. Nevertheless, flight to safety should prove USD supportive in these scenarios, particularly if asset market performance worsens. We find the argument that the French vote will shift the Fed from autopilot on gradual tightening less convincing, even on one of these ‘adverse’ scenarios.
The Fed seems to have backed down from some of its earlier concern on international developments, so even on an uptick in volatility, there should be only a marginal impact on thinking. Coupled with the fact that investor expectations Trump administration policy have diminished over time, this means that the French vote may have surprisingly little impact on broader market calculus on medium-term direction from USD. Conversely, with the pillars of USD support from the Fed and Trump policy having been weakened recently, there is little reason to believe that USD would not sell-off on an outcome which favors the centrists.
We also see JPY trading on risk aversion/appetite, but the moves might be more exaggerated than for the USD. Here, the question on longer-term impact is whether even relatively modest moves in JPY might more readily feed through to Japanese policy than is the case in the US. On a long-term basis, EURJPY is only towards the bottom of middle of recent ranges. However, a sharp move lower might provoke opposition from Japanese authorities which could mitigate downside. This ties in with last week’s Treasury Report, and intervention would be very carefully balanced.
The CHF response is the most complex. The SNB reaction function in particular is uncertain. There seems some scope for FX intervention to abate in the Le Pen/Melenchon case, and we suspect a new range is instated closer to 1.06. We find some inconsistency between priced rate cut risk and high implied correlation between EUR/CHF priced in options. A more material break higher before round 2 seems isolated to the scenario where Le Pen does not qualify. Among the more likely bullish EUR scenarios, we see EURCHF stopping short of 1.0750.
Markets price GBP correlation with EUR (via USD) between 40-50% over the French election. This looks about right to us. We doubt GBP can attract the safe haven flows JPY, USD or CHF might see. This means relative underperformance on more negative EUR scenarios (vs USD & JPY), and a lagging response to EUR rallies. We doubt particular outcomes have a significant effect on monetary policy in the first order, rather only marginally and indirectly through financial conditions.
SEK balancing risk beta and policy implications. There seems scope for SEK/EUR correlation to be even higher than GBP/EUR, with low liquidity punishing the currency during scenarios of heightened volatility. We still expect however EURSEK and EURUSD to be positively correlated and have more confidence in this being the case over the subsequent sessions. Investors should keep in mind that the Riksbank primarily view the implications of global risk through the lens of the currency. Subsequently, policymakers can be dampeners of volatility, adjusting guidance for given FX moves.
The key in gauging response from the commodity currencies is likely to be the degree to which positioning is square. Indications are that investors are running exceptionally light positions. This looks be contributing to a somewhat higher tendency among investors to trade underlying factors as opposed to using the commodity currencies as simple risk barometers. It means that downside on a ‘negative’ first round vote could be more constrained, and also skew risk-return in favor of a bigger response to a positive outcome since there seems to be little on the domestic horizon in Australia, Canada and NZ that looks likely to disrupt yield seeking. Indeed, if anything recent impact from global factors in weighing on rate expectations in these countries looks overstretched, so domestic conditions actually argue for stronger currencies.
* * *
FInally, a comprehensive summary of every possible outcome, from Kepler: