Investors Are Waking Up to the Risk of a Le Pen Victory

  • Implied volatility on German bunds is holding near the lows
  • Investors are the most bearish on the euro since June

Are Markets Prepared for a Marine Le Pen Victory?

Investors are just about waking up to the risk of Marine Le Pen emerging victorious in the French election, some early bets in the options market show.

While a Le Pen win is still seen as a tail risk and the first round of the election is still more than two months away, the unexpected outcomes of last year’s votes in the U.K. and the U.S. have raised investor awareness of political risk. The National Front candidate’s threat to take France out of the euro could call into question the fate of the common currency.

Here is where the signs of risk are beginning to emerge:

Bund Volatility

The most visible effect of any shock outcome is likely to see investors scramble for safety in bunds, with some options investors already betting that the benchmark 10-year yield may fall all the way to zero from about 30 basis points now. The implied volatility on bunds, now at around 5 percent, about half the levels seen during the so-called bund tantrum of 2015. While the chart shows that both yields and volatility are moving lockstep in positive territory, they have the potential to move in opposite directions .

Bund Call Skew

Investors in the options market are just about starting to price in higher risk of a Le Pen victory, with demand for call options on bunds having picked up recently. Still, the market isn’t yet fully pricing in the risk, with the upper panel showing that demand for puts -- which capture the possibility of higher yields -- still outstripping that for calls. The lower panel shows the increase in call options relative to puts in the past few days.

Euro Options Show Pessimism

Bearish bets on the euro are increasing, with options’ investors now the most bearish on the single currency since June. A victory for Le Pen could see renewed pressure in both the spot and options markets. Sentiment on the single currency could deteriorate further in the event of a Le Pen victory, with bearish bets -- now at 242 basis points in favor of euro puts versus dollar calls -- potentially surging to match levels around 290 basis points seen during the Greek crisis of 2015.

Credit Volatility May Rise

Investor positioning in derivatives contracts that bet on the direction of the Markit iTraxx Europe Main Index, an index of credit-default swaps on investment-grade companies, doesn’t show elevated stress as of now. One-month realized volatility on the iTraxx index is in the lower quartile of five-year range and has the potential to move higher. A regression analysis of 10-year bonds shows that Italian yield spreads and the credit index have the potential to switch to a pattern -- seen in the top half of the panel before the European Central Bank unveiled its version of quantitative easing -- where they both widen in tandem.

Credit-Default Swaps

On the credit side, the most notable reaction to a Le Pen victory would be visible in synthetic instruments such as French credit-default swaps and corporate CDS. The spread between France and German five-year default swaps is now around 29 basis points, near the levels seen in the immediate aftermath of the Brexit vote. Still, that is well below the record 118 basis points seen during Europe’s sovereign debt crisis in 2011.

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