Fundamental Analysis

Investors Take Their Breath Before French Election


EUR holds ground ahead of busy week-end

The Asian session was extremely calm on Friday as traders adjusted their positions ahead of the first round of the French presidential election that will take place on Sunday. The single currency edged slightly higher against most of its peers with the exception (obviously) of the Swiss franc. EUR/CHF was trading sideways at around 1.07.

On the surface, there is no evidence to suggest that the market is worried: the yellow metal is down 0.15%, the Japanese yen edges down 0.05% against the EUR and equities are treading water. However, in the option market it is a complete different story. The 1-week implied volatility (ATM) on EUR/USD hit 18% overnight, compared to 6.37% a week ago. The 1-week 25-delta risk reversal measure (the difference between the volatility of a call and a put) collapsed to -3.90%, indicating that investors rushed to buy insurance against further downside in EUR/USD. The same phenomenon happened to USD/JPY as traders braced themselves for a massive flight to safe-haven in case of pro-business candidates get squeeze out. Indeed, if none of Emmanuel Macron and François Fillon make it to the second round, and assuming that Benoît Hammond is already out, the EUR will take a wild ride. The worst scenario for the euro would be Le Pen and Mélenchon at the second round.

In EUR/USD, the key support stands at around 1.06-1.0630 (previous low and bottom of uptrend channel). Lower, a support can be found at 1.0341 (low from January 3rd). Investors will react violently to a squeeze out of pro-business candidates and we won’t be surprise to see EUR/USD free falling toward the 1.03 threshold. On the other hand, we’ll see a relief rally should Macron or Fillon make it to the second round (a Fillon/Macron second round would be a blessing for the EUR and French bonds). In any case, be ready for some opening gap on Monday morning.

Short JPY

The EURJPY remains the currency to watch for the market view on the French Presidential elections. Recent polls that suggest market friendly Macron has a slight lead gave Euro a boost however, terrorist acts in Paris reintroduced uncertainty (Fillon and Le Pen have suspended campaigning). Developments in European also support our short JPY call. We had anticipated a pullback in USD demand but that downwards correction in USDJPY has outpaced our expectations. We anticipate a recovery to resistance at 112.15. The JPY has been supported less by growing inflation expectations but rather weakening in global risk environment. JPY remains the dominate risk aversion trade above gold, USD and CHF (however, we are not seeing significant JPY buying on fluctuations in French polls). Clearly rising geopolitical worries have caused investors to rotating out of risky asset and into JPY. We suspect tensions have reached a peak and suspect that the historically customary path of diplomacy with takeover. IMM positioning indicates that the JPY is well overbought suggesting room for readjustments. This week BoJ meeting will bring no bring meaningful adjustment to the current strategy as policy board member are likely to shift focus on personal changes rather than monetary policy. Last week the BoJ nominated two very dovish member show support aggressive balance sheet expansion to its committee. For now the realization that the BoJ ¥80trn annual balance sheet expansion was unstable leading to a switch to yields curve control will dictate strategy. While the ECB inches towards tapering and Fed contemplate the next 25bps hike the BoJ policy continue to be the loosest. This strategy should remain supportive of USDJPY.

Yet, it is not the BoJ that will drive USDJPY higher but the reactions of the US economy and interest rate. US economy seems to have slipped into a period of cyclical softness which should organically pick-up in early summer. However, while investors have all but thrown the Trump-reflation trade always there is still the probability that that the Trump administration gets a pro-growth win (tax reform remains the clearest). IMM data indicates that USD is oversold indicating room for additional demand. In addition implied yields on Fed Futures for 2017 are near the lowest they have been in 2017 and 2018 suggesting it would not take much for markets to quickly reprice the pace of Fed interest rates hikes. Sending USDJPY higher.

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