Frexit Risks Help GBP/EUR Exchange Rate to Fresh Two-Month High

The British Pound has fallen back  from a fresh two-month high against the Euro as markets weigh the prospects of Marine Le Pen might win the French Presidency.

The Euro has struggled ever since a poll by OpinionWay for ORPI, Les Echos and Radio Classique showed the leader of the Front National has reduced the gap behind both Macron and Fillon in the second round of voting.

The poll showed Macron would defeat Le Pen by 58% to 42% in the second round. His advantage has halved in less than two weeks.

"It’s all about security. Le Pen is benefiting from the fact that they’re all busy either bickering or unable to disentangle themselves from their many controversies." A separate Harris poll showed that Le Pen is considered best placed to deal with security issues," says Bruno Jeanbart, director of OpinionWay.

Another poll for L'Express by Elabe shows Le Pen is now polling above 40% for the second round against both Fillon and Macron for the first time.

The same poll shows a recovery by Francois Fillon - the Republican candidate - against his rival Emmanuel Macron. As we note here, a Fillon win has positive conotations for Sterling longer-term on his views concerning how Brexit negotiations should be conducted.

Fears Le Pen will take France out of the EU, and thus potentially causing a political and economic storm in the region are depressing appetite for French debt and the Euro.

"The French elections are becoming an increasingly relevant risk to markets, with the chances of a victory for Le Pen rising with every month that passes. As the spread between French and German 10-year bond yields rises to a 4-year high, it is clear that the markets are increasingly factoring in a Le Pen victory as a distinct possibility. However, if there is anything we have learnt from polls in the UK and US, it is that the more controversial option can often be underrepresented up until the vote," says Joshua Mahony, a Market Analyst at IG in London.

From previous odds of winning the presidential election of below 0.1% analysts at SEB Bank are placing Le Pen’s odds of winning now at as high as 40%.

“The spread of sovereign bonds in France versus Germany widened yesterday as a new poll suggested the presidential race is getting tighter. With the current polling it looks like Le Pen will compete against either Emmanuel Macron or Francois Fillon in the 2nd round of the elections. The poll showed a small uptick in the probability of winning against either candidate," says says Lars Merklin at SEB.

However, with little over two months till the election, Le Pen is still substantially behind and estimates put her at around 40% chance of winning in the second round. 

Her agenda to leave the EU and the EUR would require Parliamentary approval and hence represents an unlikely outcome.

"However, a potential scenario of a hard left or hard right future French President could perhaps reduce Franco-German co-operation which could potentially disrupt EMU for years, leaving the ECB in charge, which might win time by introducing a policy of prolonged period of negative real rates and yields," say Morgan Stanley in a strategy note sent to clients ahead of the week commencing February 20 that hints at Euro weakness in coming months.

Regardless of the odds remaining low for a Le Pen victory, they are changing in her favour nevertheless.

“Macron has seen his odds of winning the election slide, as Marine Le Pen has seen her chances rise. Although Macron has a near 38% chance of winning in May, Le Pen is not far behind at 34%, and momentum appears to be on her side,” says  City Index’s Kathleen Brooks in a note to clients.

Brooks notes that whilst polls have proven unreliable in the British referendum and US presidential election, odds trackers such as the chart above have proven more reliable.

French Bonds fell below those of Irish bonds on the increased political tension, and are poised to almost tumble below those of Spain if election woes worsen.

Bonds are a useful guide to currency markets as their prices move inversely to currencies since they are an inflation gauge and currencies tend to appreciate as rising inflation drives up interest rates.

“France’s 10-year spread with Germany has been rising at a much faster rate than other European bond spreads in Europe during February, which has coincided with Le Pen’s increasing chance of winning the Presidential election. This chart suggests that the there is some panic amongst bond investors, who are starting to worry (read, price in) the tide of momentum that seems to be with Le Pen’s candidacy,” says Brooks.

Le Pen is Toxic for the Euro, argues Brooks, and highlights the 1.0500 level as a key battleground off Bulls and Bears on the EUR/USD rate.

“We will watch what EUR/USD does at 1.0500, there is some key support at this level. However, if it falls through 1.0500, then EUR/USD could find itself testing the 2017 lows so far at 1.0341,” she comments.

Le Pen Risks Overblown, buy the Euro

Of course note everyone is convinced by Le Pen's march.

RBC Capital Markets reckon there is almost no chance of Marine Le Pen winning the French presidency, yet markets have priced this outcome quite aggressively.

Analysts at RBC Capital reckon there is only a 0.1% probability of Le Pen winning and therefore the Euro is weaker than it should be.

“It may sound foolhardy given the experience of Trump and Brexit, but we think markets are overpricing the probability of a Le Pen victory in the second round,” says Lisa Lignos at RBC Capital Markets.

Lignos believes that there is a material chance of the Euro rising as the misjudged political risk is unwound following her probable failure.

She recommends buying EUR/USD put options to profit from an expected rise in the Euro.

Also suggesting that markets might be over-egging the Frexit risk is Lars Henriksson, an FX Strategist with Svenska Handelsbanken AB - the Swedish banking and financial services firm.

"It seems evident that she will lose the second round," says Henriksson, "therefore, a “Frexit” is highly unlikely. We are more worried about the state of the Italian banks as more banks are lining up for government support".

The problems surrounding Greece are also back on the table and it remains clear that this seemingly endless back and forth between a deeply dysfunctional Greek economy and its lenders will continue until the voters on either side say enough is enough.

Indeed, Grexit is arguably a more realistic outcome than Frexit.

Give, economic data in the Euro area is showing strength and is beating expectations at a pace we have not seen for almost two years.

"However, political uncertainty will limit the Euro’s potential for some time to come," says Henriksson.