The state of play with the French elections

To provide context on the state of play, the various polls on voting intentions for the first round election on 23 April suggest far right candidate Marine Le Pen and centrist Emmanuel Macron should get the votes needed to face off in the run-off vote on 7 May. Most polls (on voting intentions) suggest a fairly comfortable win for Macron in any head-to-head battle, with Le Pen at around 37%.

Emmanuel Macron the clear favourite

In fact, the polls suggest Fillon would even beat Le Pen fairly comfortably if Fillon and Le Pen get the most votes in the first round and face off on 7 May. This outcome seems very unlikely though, given the sheer magnitude of the allegations against Fillon and his wife. However, it’s also not mathematically improbable.

French voters tend to see elections as one where you vote for the candidate you want to win in the first round and then against who you fear in the second round. Without a doubt, the big uncertainty for voters and financial markets comes from a Le Pen presidency, so this seems to be the key factor in why Marine Le Pen is expected to do so poorly in a run-off vote on 7 May.

Importantly, don’t discount a very high abstain rate, with a recent poll suggesting some 37% of voters suggesting they would not put in a vote. Could this play a key role in affecting the final result, especially as those who are likely to abstain are more likely to vote for anyone else than Le Pen?

The bookies' odds

Oddschecker currently has Macron taking the presidential election with a 62% probability, while Le Pen and Fillon have 25% and 19% respectively. This implied probability seems to be resonating through markets and French and EUR assets more broadly, with a certain calm seen across multiple asset classes.

Market moves

If there is any real stress in the FX market, it isn’t reiterated in positioning held by speculative funds.  Where we can see the net short position held by FX futures, trading accounts (as reported in the weekly CFTC report) having been reduced from -160,000 contracts in November to current sit at -59,943 contracts.

We can see EUR/USD one- and two-month implied volatility is still below the 12-month average. We can also see the EU 50 volatility index futures curve has flattened quite considerably in recent weeks, and even if we look at implied volatility over the May contract, we can see traders are not positioned for a sizeable pick–up in range expansion.

Traders can trade EU volatility with IG, so this index (reflecting implied volatility) is worth putting on the radar.

Perhaps the best way to view stress in French assets and what the institutional traders will look at closely is the yield premium demanded to hold French debt over German debt.

Marine Le Pen is promising to take France out of the European Monetary Union (EMU) and back to the franc. This in itself is extremely complicated from a legal perspective, but if successful could constitute a default as much of the outstanding French public debt would legally be worthless. With France’s E2 trillion public debt redenominated into the franc, we would in effect see the world’s biggest ever bond default. So, if traders genuinely felt Marine Le Pen was going to win, then you would not want to be holding French debt and we would be seeing France’s two-year bond yield trading far higher than 47bp above Germany’s two-year bund – even though that is now at the largest spread since 2012.

This yield premium is increasing and the spread really does need to be monitored as it is the key gauge of stress in holding French assets. I would expect the EUR and even the CAC index to come under pressure if it widens substantially from here.

The legal hurdles ahead

So a vote for Le Pen is a vote for increased domestic security and far tighter immigration laws. It is also a vote on the Banque de France to regain independence from the ECB and a move away from the euro. If Le Pen wins, there is a very complicated process ahead in removing France from Europe and to even call a referendum on future inclusion in the euro. Le Pen would need Parliament's authorisation for amending Article 88 of the Constitution dictating participation in the European Union, and potentially also a change on Article 11 on even calling a referendum. This authorisation would need support from at least 185 MPs from both the French National Assembly and Senate to progress.

The sheer complications involved would explain why French assets are currently subdued. Not only do traders feel Le Pen has a low probability of winning, but if she does take the presidency she not only has to jump through a number of legal hoops but then has to see the French public vote to leave the union in a referendum. In late 2016, the European Commission compiled a survey across 13 EU countries and close to 70% of French respondents had a favourable vote on Europe.

So while the prospect of a Le Pen win seems low, there is little doubt that a victory for Le Pen on 7 May will send shock waves through markets and will cause at least a 10%+ sell-off in the CAC index, with French banks likely to be punished. The EUR would find limited buyers and a wall of selling, with short EUR/JPY the key trade.

However, a victory for Macron is the clear base case and this could cause a modest relief rally as his policies are less extreme, involving strong support for the EU and a pro-business stance.

One way to look at a run-off vote between Le Pen and Macron is that this is the ultimate showdown between protectionism and globalisation, and this could be the key consideration for voters.

As we have seen in Brexit and the US election, political outcomes are tough to predict and we have seen just how bad participants have been at positioning for outcomes. Prepare for the unexpected.