Latest Euro Predictions on French Presidential Elections: The JP Morgan View

• Pound to Euro exchange rate: 1 GBP = 1.1714 EUR
• Pound to Dollar exchange rate: 1 GBP = 1.2433 USD

One month to go before the French elections and we now have four potential winners with the waters being muddied by a late surge by far-left candidate Jean-Luc Melenchon making notable strides.

The increased uncertainty saw the shared currency turn softer as the latest round of French opinion polls confirm Melenchon continues to make decent strides.

The candidate is seen commanding some 18% of the vote in the first round, just ahead of Francois Fillon.

Both are still well behind Emmanuel Macron and Marine Le Pen who are both tied at 24%.

“The increased congestion in the polling, added to the level of indecision among voters, may yet give the Euro a fright and patient Euro bulls a really attractive entry point,” says Kit Juckes, analyst with Societe Generale.

Markets are starting to toy with a scenario whereby Melenchon pips Macron into the second round creating a situation in which a far-left candidate measures up to a far-right candidate.

This could make it harder for moderate voters to galvanise around a more centrist candidate in order to block a Le Pen victory.

The pollsters note, however that given the margin of error on these polls there are now effectively four candidates with a realistic chance of making it to the second round of voting.

The latest Kantar Sofres poll for le Figaro, RTL and LCI projects a second-round run-off between Melenchon and Le Pen would have a 57-43% result, tighter than the 61-39% projected for a Macron-Le Pen run-off.

Cross asset markets are warning us to not be complacent - in particular the dynamics in European equity volatility and the French-German yield spread.

Since its all-time low on the 17-Mar, Eurostoxx volatility (V2X) has more than doubled, while the 2yr French-German yield spread widened almost 9bps yesterday and now sits at its widest level since mid-2012.

"Add to that the clear bias towards puts in the 1m EURUSD risk reversal (which from last Friday includes the second round of the French election), now at its most bearish since late 2011, and we have a variety of indicators highlighting the rising political risk," says analyst Robin Wilkin at Lloyds Bank.

For now a Le Pen win outcome is still not favoured, but how low would the Euro were Le Pen to win the election? Equally important, how high can it go if she is defeated?

Euro Losses to be 'Tame' Should Le Pen Win

Analyst Meera Chandan at JP Morgan has crunched the numbers and notes that investor positioning is not as short on the Euro has has been the case in the past.

"Thus it seems that the Euro has decent downside on a Le Pen victory as the market prices in the possibility of EMU exit," says Chandan.

The Euro could fall to about 0.98 against the US Dollar over a few weeks which will place notable downside pressures on the Euro / Pound exchange rate.

"This tame view reflects our judgement that technically-driven position adjustment is the main bearish force, since Europe has many mechanisms to prevent French political uncertainty from generating the sort of financing stress required to deliver a significant demand shock too," says Chandan.

The above scenario assumes that Le Pen will not necessarily succeed in taking France out of the Eurozone and European Union; therefore our interpretation is that JP Morgan anticipate markets see such an event as being a long-term risk.

But, while JP Morgan say that while they continue to anticipate a mainstream outcome in the elections, in the event of a Frexit (should Le Pen win and then succeed in her agenda of taking France out of the Eurozone and then European Union), a 10% to 20% TWI depreciation in the local currency would seem reasonable.”

This would take the Pound / Euro exchange rate back to levels it was seen trading ahead of the Brexit result in the 2016 referendum which is roughly around 1.35-1.40 as the UK would almost certainly benefit from a flight to safety.

But while risks remain, market consensus does still assume mainstream parties prevail.

Chandan says that this outcome, when combined with a less-dovish ECB, should eventually result in EUR strength.  

What happens if Len Pen Loses?

JP Morgan reckon the Euro might only rally 2 to 3 cents on short covering, since the base is small.

Moreover, maybe some investors will simply shift focus to Italy. But if Italian elections might be a year away, markets will move in the interim.

For JP Morgan, the wildcard is cross-border equity flows, which have looked weaker for several months than what Europe’s cyclical environment justifies.

Analysts are less confident on precisely how much inflow might materialise since Italian politics will always deter some investors.

“So for now, consider equity positioning a source of Euro upside risk rather than a necessary condition for outperformance,” says Chandan who points out that for the currency it is ECB policy which is more critical.

Should the central bank look to withdraw its monetary stimulus (quantitative easing) and start raising interest rates earlier than markets are currently expecting then the Euro could really see some upside.

Pound Forecasts Upgraded

The latest forecast update from JP Morgan comes as Sterling is seen performing better over the past month than many analysts had expected.

“The trade-weighted index looked to be breaking down in March on evidence of a broader economic slowdown, but has since rallied 2% on a combination of better macro-economic and political news,” says Paul Meggyesi, a foreign exchange analyst in JP Morgan’s London office.

Meggyesi still expects a weaker GBP over time as the UK economy underperforms and real yields decline to nearly -3%.

But, JP Morgan see upside risks to their forecasts for the pound an have lifted their headline GBP/USD forecast a percent in recognition that the economy might not slow as much as they had initially feared.

“The current account deficit that has already halved, and a more conciliatory tone from the government towards the Brexit negotiations that holds out hope of a transitional deal and a less disruptive exit,” says Meggyesi.

Analysts doubt whether the Pound to Dollar exchange rate will sustain moves below 1.20.

The forecast for EUR/GBP is cut from 0.88 to 0.87 (mid-year) and from 0.92 to 0.91 (end-year).

This equates to a Pound to Euro exchange rate upgrade from 1.1364 to 1.1494 for mid-year and 1.0869 to 1.0989 for the end-of-year.

The bank forecasts the EUR/USD exchange rate at 1.08 by September ahead of a rise to 1.15 by the end of the year.