European Interest Rates
The outcome of the first round the French presidential election will likely dominate global yield behavior over the coming two weeks. Whether the impact will be limited to that period or last longer will depend on the outcome. In our view, the risk of surprise is higher in the first round, given how closely bunched together candidates’ poll numbers are (Macron 23%, Le Pen 22%, Fillon 20%, Melenchon 19%). It appears likely that the candidates’ final poll readings could end up within the margin of error ahead of the election, making it hard for markets to price out this risk ahead of actual results. The main reason, of course, is that both Le Pen and far-left candidate Melenchon are staunchly anti-EU, and a victory by either would be highly disruptive for both France and Europe more broadly. Alleviating some of the tight polling in the first round is the fact that the second round polls show a comfortable margin for either mainstream candidate (Macron or Fillon) in a head-to-head matchup with Le Pen. Even here, however, there are some risks, as there’s more of a mixed result versus Melenchon. The real risk to markets then, appears to be Melenchon making it to the second round. We discuss how interest rates markets may react to the various outcomes in the first round below. The first, and more likely scenario in our European economists view, is that Le Pen and Macron will be the top two finishers in the first round. In this case, polls indicate that Macron is expected to win fairly easily in the second round, having consistently led by about a 20 point margin—markets would view this outcome as fairly benign. We had estimated previously that there was about 25bp of “redenomination risk” premium in Bunds.

Since then, more of this negative premium has been priced into German sovereign debt, and we now estimate there’s about 35bp. Some of this is likely to be unwound immediately following this outcome in the first round, though not the entire 35bp as the second round polls are still over two weeks away. In terms of peripheral spreads, this would mean compression, given that they are currently close to their widest levels seen in the past few years. Some caveats are in order; in the event that Le Pen wins with a much larger margin than current polls show, the selloff in bunds may be rather muted, given that a surprisingly large margin could reveal some polling issues.