France goes to the polls this Sunday in what is sure to be a market-moving event. Marine Le Pen’s National Rally (RN) has solidified its support and polls, with allies, on 36%. Macron has about 20%, whilst the left-wing alliance has about 29%. A ding-dong of extremes is the new reality.

I don’t think markets are really braced for this one yet. A victory for RN would almost certainly lead to confrontation with the EU. Economic policymaking is less clear, but markets hate the uncertainty. France’s budget profile is already shaky. RN has dropped a pledge to leave the Euro – this is not really about Frexit as such (at least not yet), but the inherent instability from what’s frankly a bit of an unknown quantity. 

There have been signs of stress – Franco-German spreads are at their widest in more than a decade on the uncertainty.

Chart: Reuters Eikon

The rise has exceeded the last spike which we saw in 2017, just before the first round of the presidential election that year. Macron’s win in the first round, which led to a run-off with Marine Le Pen, saw spreads tighten again as markets bet on a Macron victory.

Markets are showing signs of nervousness again after yields pared back a touch after initially spiking on the EU election results and Macron’s immediate calling of a snap election. This morning we have a fresh high for the spread.

Chart: Reuters Eikon

Still I feel that the market is underestimating the shifts are happening in France. We should be seeing more stress in bond and equity markets and I think we will see more come Monday.

This is not Greece. France is 16.5% of EU GDP whilst Greece is just 1.3%. Moreover, when the collapse of Greece looked likely, the exposure of banks to Greek debt was not that high. It is different this time.

Here is a chart from Costas Milas at the LSE. It shows the risk of contagion via the banking channel from a potential meltdown in France.

Source: Author’s calculations based on data from the Bank of International Settlements.

And one could argue that France’s finances are already messy. Debt-to-GDP is about 110%, and it ran a budget deficit of 5.5% last year. It’s already on the EU’s budget naughty step. A swing to the right would provoke more trouble on this front.  

I think that if things get ‘worse’ in France – higher yields, wider spreads, financial instability, the ECB would step in. The EZ is a political project as much as an economic one and the ECB would do ‘whatever it takes’ to shore things up. Mario Draghi, then ECB president, famously stated in 2012, at the peak of the European sovereign debt crisis, the central bank would do ‘whatever it takes’ to save the euro. Nothing has changed since then to indicate the ECB would not intervene again should it feel necessary. In fact, quite the opposite. The Bank of England might have to join it if UK banks feel the heat and bond yields rise globally.

Of course, markets may well be overreacting. They tend to do so when pricing extremes; and they may overreact more in the coming weeks. Investors are not very good at pricing political risk. Investors are waking up to the possibility of France veering decisively to the right. The assumption is far-right done good = fragmentation tail risks, policymaking trade-offs and inertia, lower immigration, higher fiscal deficits, protectionism…but France’s debt profile is fragile anyway and it is not entirely clear whether the RN would do worse than the current government. There is an argument that an RN government could be more fiscally prudent than the Macron centrists would be. But the market will price for greater risk. 

In summary, political risk premia are rising, yields are likely to rise further, spreads widen and the ECB and BoE may need to get their scissors out. 

Neil Wilson

Chief Market Analyst at Finalto

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