The Politics

The French presidential election is rapidly becoming one of the most unpredictable contests of recent years — even bearing in mind the U.K.’s decision to leave the European Union, and the election of Donald Trump as president of the United States. The markets have already started to sniff trouble, doubling the spread between French and German bonds in the space of just a few weeks (widest level in three years)

As the election gets closer and closer — and it becomes clear that none of the candidates have a credible program for reviving the French economy — that spread is only going to get wider still. Betting against the French government bond market, the fourth biggest in the world after the U.S., Japan and Italy, is now the easiest trade in the world.

Three things have happened since then to throw the race wide open:

• First, the Socialist Party has chosen the far-left Benoit Hamon as its candidate. His policies? He wants to take the 35-hour week down to just 32 hours, and introduce a universal basic income at a cost of more than 400 billion euros
• Next, Fillon has come under investigation for the vast sums paid to his Welsh-born wife Penelope. it is very hard to see how he can campaign as a reformer with those allegations hanging over him
• Macron has emerged from nowhere, and now has the momentum behind him. The former finance minister has formed his own party and its running on a campaign of reform and renewal. He is closing fast on Fillon for the crucial second-place spot in the first round

Two of the candidates (Hamon and Le Pen) would be catastrophic for the economy. Le Pen has threatened Trump-style protectionism, and threatened to pull out of the euro, but with no clear plan for how to get there. Hamon makes wildly unrealistic spending promises, with only a tax on robots to pay for them.

Fillon and Macron are far more credible — but only up to a point. France is totally unprepared for Fillon’s promised cuts in state spending, and the last thing France needs is a president who limps into office with a weak mandate, and then spends the next five years fending off prosecution.

Macron might be the youngest and freshest of the candidates, and very soon he will the favorite of the markets and big business. But his policies are so vague, he would have little idea what to do in the Elysee Palace. As finance minister, he talked a good game, but ended up achieving very little — deregulating bus routes was one of his few substantial achievements

The blunt fact remains that France has lost competitiveness relentlessly ever since the euro was launched. In 2000, its share of the Eurozone goods and services exports was 17%, according to report by COE Rexecode. In 2016, that was down to 13.4%. Between 2015 and 2016, it lost another 0.2% of market share.

How Markets will be affected?

1. An increase in political risk premium in French bonds should result in some widening in the yield spread over core countries, such as Germany. The France-Germany 10-year yield spread has been gradually increasing since November, but that may have been influenced by French bond sales and reduced buying support from the ECB.

2. The brunt of any selling would likely be felt in the liquid futures market of the French 10-year bond, as was the case after Trump’s election victory. Investors often look at the open interest — the active number of bets — which can leave footprints as to when positioning changes. Currently, front-month OAT futures have a record-high open interest, which may increase as we approach the election.

3. France’s five-year credit-default swaps have retraced about 50 percent of the post-Brexit gains following Trump’s election victory.

4. The outcomes will be key to the stability of the euro and, in the medium term, to credit risk.

5. Banking stocks, which have been the most sensitive to concern about the fate of the euro zone, are the most vulnerable to rising political risk. French automakers, which have a strong exposure to Europe, would also feel the impact.

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