Euro falls, left braces for surprise victory over Le Pen in French elections

(Bloomberg) — The euro fell after early projections for France’s parliamentary elections pointed to a surprise victory for the left-wing alliance, a result that traders had largely discounted and that has the potential to reignite market turmoil.

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The single currency was down 0.3 percent at $1.0807 at the opening of trading in Sydney. Early projections show the New Popular Front, which includes the Socialists and the far-left France Insoumise, is set to win between 170 and 215 seats in the National Assembly. Marine Le Pen’s far-right National Rally, which was widely expected to win the most seats, came in third, after President Emmanuel Macron’s centrist alliance.

While fund managers have spent the past week fretting over Le Pen’s continued rule, a left-wing victory is the outcome most feared by markets since President Emmanuel Macron’s surprise decision to call an election. The left-wing alliance has repeatedly pledged to push for a major increase in government spending, heightening concerns about France’s already bloated balance sheet and putting the country on a collision course with the European Union, which is already taking steps to cut the deficit.

“French policy is once again confusing,” said Geoffrey Yu, senior strategist at Bank of New York Mellon. “Given the results, the risks of expansionary fiscal policy remain and may have increased to some extent.”

Even though the left-wing alliance has little chance of winning an absolute majority – which could limit its possibilities for action – the result will inject a new dose of uncertainty into French assets in the days to come.

French markets plunged in June, wiping out billions of euros of stocks and bonds. But over the past week, traders have pared some of those losses as opinion polls have indicated the National Rally will fall short of an outright majority. Last week, France’s CAC 40 index erased about half of the losses it suffered following Macron’s announcement.

The picture painted by early projections Sunday night is very different: Macron’s centrist party, favored by investors, is on track for second place, despite a poor first-round showing. The result could allow the president to assemble a centrist coalition.

The inevitable political wrangling and concerns about left-wing influence could nevertheless push up the yield on the country’s 10-year bonds, OATs, and widen the gap with safer German bonds. The gap had narrowed to 66 basis points on Friday, after soaring to more than 80 basis points last month, levels not seen since the euro zone sovereign debt crisis.

This “shocking outcome” could easily push the spread back above 80 basis points, according to James Rossiter, head of global macro strategy at TD Securities. “Rates markets entered the election with the spread between OATs and German interest rates in a hung parliament scenario – but a hung parliament led by the RN, not the NFP,” he wrote in a note.

French bond futures resume at 2:10 a.m. in Paris, followed by cash bonds at 8 a.m. and stocks at 9 a.m.

France is already struggling with a budget deficit of 5.5%, which is well above the 3% of GDP allowed by European Union rules. The International Monetary Fund projects that without new measures, the debt would reach 112% of GDP in 2024, and would increase by about 1.5 percentage points per year over the medium term.

Vincent Juvyns, global markets strategist at JP Morgan Asset Management, said tensions were likely as Macron’s reforms were now being called into question, which could hurt the value of French bonds relative to their peers.

“Markets may demand a higher spread until the new government clarifies its budgetary position,” he said. “The European Commission and rating agencies expect budget cuts of €20-30 billion, but the government will actually have to face a party that wants to increase spending by €120 billion.”

–With the collaboration of Julien Ponthus and Vassilis Karamanis.

(Updated with new commentary on fourth paragraph, additional context throughout)

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