Global Markets Comment: Market-Based Estimates of French Election Shifts

• Prediction markets strongly favor a win by President Macron over Ms. Le Pen in the second round of the French presidential election on Sunday April 24. However, the situation remains fluid, and comparisons with 2017 may be leading investors to be too sanguine about both the probability and the impact of a Le Pen victory.
• Our strategy teams in Europe have set out their fundamental views on how major assets would trade under each scenario. The last two weeks have given a clearer picture of market reactions to shifting odds of the presidential winner. We use those shifts to generate market-based estimates of the potential reactions as a complement to the fundamental analysis that the team has provided.
• Our results are broadly consistent with our strategy teams’ fundamental estimates, both directionally and in terms of order of magnitude, but give somewhat larger estimates of the potential shifts in both sovereign spreads and FX. Comparing these simple benchmarks across assets suggest that there is still scope to hedge for deeper tail risks particularly in some EUR crosses (EUR/SEK, EUR/$ and EUR/GBP) and potential asymmetries in sovereign spreads, though tomorrow’s ECB meeting could also affect these assets. Campaigning over the long weekend and the televised debate on April 20 are the next important milestones.

Market-Based Estimates of French Election Shifts 

As was widely expected, the first round of the French presidential election has led to a run-off between President Macron and Ms. Le Pen on Sunday April 24. Although prediction and betting markets at this point strongly favor a Macron win, the situation is still fluid . Uncertainty about turnout and the voting preferences of those who supported other first round candidates as well as the remaining campaign period (including a debate on April 20) could still shift those odds. Comparisons with 2017 are leading investors, in our view, to be too sanguine about both the probability and the impact of a Le Pen win. While Ms. Le Pen is no longer outlining a path to leaving the Euro area as she did in 2017, the shifts to French and European policy paths are still likely to be significant if she were to win the Presidency, given the strong support President Macron has given to deeper European integration andmutual support.

Our strategy teams in Europe have already set out their fundamental views on how major assets would trade depending on the winning candidate. Alongside these fundamental estimates, we now have a clearer picture of market reactions to shifting odds of the presidential winner than we did two weeks ago. After remaining remarkably sanguine about the outcome, prediction market probabilities of a Le Pen victory rose sharply from April 1 to April 8 (from 11pct to 27pct). Those probabilities declined to around 17pct after a somewhat larger-than-expected margin of victory for President Macron on Monday April 11 as markets reopened after the vote and currently sit at roughly 15pct. In the process, a range of European assets sensitive to the outcome appear to have moved with those shifting risks.

As a result, we can calculate a simple market-based estimate of the victory of either candidate for those assets as a complement to the fundamental analysis that the team has provided. To do that, we proceed in a similar fashion to our initial estimates of the pricing of risks around Ukraine invasion risk. We look at the performance of assets over those two periods of shifting election odds (April 1-8 and April 8-11). We then obtain an estimate of the asset impact of a 1pp increase in the prediction market probability of a Le Pen victory by looking at the performance of assets in each period versus the change in probabilities, and take the average over the two episodes. We then use those betas to calculate the implied moves in assets if the probability of a Le Pen victory moved to 100pct or 0pct. Exhibit 1 shows those estimates across some key assets, focusing on those that may still be suitable for hedging purposes.

This approach implicitly assumes that the asset moves over these periods were predominantly driven by shifting election odds. Given the many crosscurrents in markets, that is unlikely to be literally true—for example, not all Euro-area exposed assets retraced over the weekend in the wake of the first round results—but by focusing mostly on assets that are most sensitive to the election, and on relatively short periods, we hope to minimize that risk. Compared to 2017, there have also been fewer episodes where shifting market perceptions of the election drove assets (essentially only the episodes we analyze here), which also lowers confidence in market reactions. While a fundamentals-based approach is thus likely to be a more reliable guide to where assets ultimately trade, we think this market-based approach provides potential clues to shorter-term market reactions.

Our results are broadly consistent with our strategy teams’ more detailed work, both directionally and in terms of orders of magnitude. For both sovereign spreads (particularly for OATs) and FX, however, the market-based estimates tend to be somewhat larger than those fundamental-based estimates, though it is possible that hedging flows last week as election focus increased may be leading to an overestimate of the shifts from a final outcome. Comparing these simple benchmarks to options volatility where available, these benchmarks suggest that there is still scope to hedge for deeper tail risks particularly in some EUR crosses (EUR/SEK, EUR/$ and EUR/GBP screen most favorably) and potential asymmetries in sovereign spreads too, particularly after the recent compression. This group of assets is also the group that, for the most part, behaved most symmetrically around the two shifts in prediction market probabilities.

As with any cross-asset hedging exercise, the risk is that other factors intervene ahead of the event. In particular, this same group of European assets is also sensitive to any major shifts in tomorrow’s ECB meeting, so the risk is that this could disrupt hedging performance if assets trade away from strikes. For those expecting a more hawkish shift ahead of the ECB, sovereign spreads would likely be a more attractive hedge ahead of the event, while FX hedges could be more attractive after it. In the case of significant moves around that event, we will update our estimates of asset levels to take account of those shifts. Beyond that, campaigning over the upcoming long weekend and next Wednesday’s televised debate could be important milestones .