The Priced-In Risk of Marine Le Pen's Victory
Markets trade in the probability of certain events happening. In case an event has high risk, a “tail” is priced in. Those tail risks typically show up in certain corners of the markets. Today, tail risks are priced in for a potential unexpected outcome in the French elections. That tail risk is on the rise now that polls of the second round of voting indicate a tight race between center candidate Emmanuel Macron and the far-right candidate Marine Le Pen.
Tail risks can be viewed in a linear way. For example, the German 2-year bond ("Schatze") reached an all-time negative yield of -92 basis points when Le Pen recently gained in the polls. As a result, the German 2-year yield became negatively correlated with the price of French bonds and stocks. A generic view is that German bonds are a reflection of the “tail risk” that Le Pen is victorious. However, there are technical reasons to explain the fall of German 2-year bonds. Those technicalities are a scarcity of German bond collateral in the repurchase market and the European Central Bank's purchase of German bonds yielding less than the deposit rate. This is what makes the 2-year German bond “overvalued” and therefore not as accurate a reflection of the true tail risk in France. There are other areas in markets that provide a better idea of how much of a Le Pen win is priced in.
Tail risks can be seen in currency options. The options market use a measure called “skew.” This is the difference between the implied volatility of puts and calls. A negative skew means currency markets price euro puts with higher implied volatility than the currency's calls. In the case of negative skew, the currency market thinks the risk for depreciation of a currency is large. The skew of the euro currency has been on a steady decline since President Donald Trump was elected in November, as seen in Fig. 1.
On the other hand, the French bond market has seen a surge in yields discounted to the second round of the presidential election, on May 7. Rising yields are a sign of uncertainty about the outcome of the election. Fig. 1 shows how markets are pricing a “tail risk” of an adverse election outcome. And this tail risk seems to be increasing by the day.
A different way of estimating the tail risk of a French exit is via sovereign credit default swaps. In 2014, the definition of sovereign CDS changed to represent “English law” issued bonds that reflect the “bail-in” rules for European financial institutions. Since then, the sovereign CDS market has seen two versions: the “2014” definition and the “2003” definition. The latter is based on “local law” sovereign bonds. Under local law, a government potentially has more leeway to restructure sovereign debt less favorable to bond holders.
The French government bond market is currently around 2 trillion euros, of which about 1.7 trillion is issued under “French local law.” In the event of a “Frexit” after a sweeping electoral victory by Le Pen’s Front National, restructuring risk of French government bonds may rise significantly. The tail risk of that possibility is shown in Fig. 2 where the spread between 2003 and 2014 definition French sovereign CDS has widened sharply.
In another segment of the market, spreads on supra/sovereign and agency bonds have moved sharply versus French sovereign bonds. A similar signal of a risk of potentially more financial distress is seen in swap spreads, the difference between German yields and euro swap rates, as shown in Fig. 3. These risk spreads have widened close to levels of 2011 at the height of the euro crisis. The SSA market consists of issuers such as the European Investment Bank. Such institutions are funded by 27 countries in the European Union, including France. A widening of French spreads to the EIB is a signal the market is considering the possibility that France may not be able to provide future funding to the EIB in the event of an exit from the European Monetary Union.
Despite the esoteric tail risks of a “Frexit” in specific segments of European sovereign and derivatives markets, global sentiment has remained fairly optimistic about the outlook. This is the result of a market currently trading between an “upside risk” scenario of U.S. tax reform and fiscal stimulus, and a “downside risk” scenario of different election outcomes in Europe.
In 2007, certain segments of the mortgage derivatives market predicted a big risk event in housing that ultimately led to the 2008 financial crisis. Ten years later, in 2017, the French bond, CDS and currency markets are discounting the possibility of bigger political risk that may eventually lead to what is dubbed the “Frexit.” The difference between the Brexit and Frexit is that the latter is a possible exit of the monetary union. That carries the risk of currency redenomination, default and financial stress. For now sanguine global markets should start paying closer attention to what the tail risks in French markets are saying. If tail risks are to be believed, the risk of Frexit is larger than what is currently assumed.
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