“Genuinely Scary Moments Are Ahead,” One Trader Warns

On Monday, I explained why I like my term structures kinky.

Europe is trying – bless its heart – to price in political risk associated with the trio of big elections this year, but it’s hard to price something so indeterminate.

As I’ve noted, the VSTOXX term structure has a notable kink…

vstoxx2

(Goldman)

…and French and Dutch spreads to bunds are widening…

spreadsdutchoat

(Citi, BofAML)

But is this enough?

That is, are markets accurately appraising the risk here?

According to FX trader turned Bloomberg contributor Mark Cudmore, the answer is definitively “no.”

Via Bloomberg

Europe has some genuinely scary moments ahead in 2017. Expect the euro to be the trending casualty, while the much bigger bond moves may come later.

  • The first thing to clarify is that, while spreads in Europe have widened a little bit in recent months, markets aren’t pricing in any serious political risk. French 10-year yields are only just above 1% — they were twice as high three years ago. In fact, it was not until November 2014 that they’d dropped as low as the current level
  • Some might object that this overlooks the spread-widening to German bonds. But that spread is half the level it was in both 2011 and 2012, when France was still considered part of the core
  • The structure of the French voting system makes it hard for Le Pen to become president, but the fact that she’s extremely likely to be one of only two candidates in the 2nd round, and with the largest share of votes from the first round
  • The Brexit vote and the U.S. presidential election have shown that non-mainstream candidates or causes have been able to motivate people to turn out and vote. So once Le Pen is in a two-horse race, markets will be compelled to price in a much greater risk premium
  • The larger European bond move will occur then. There may be some bursts of selling associated with the Dutch election and other incidents, but France is the main event. In the interim, expect the euro to bear the brunt of pressure
  • The joint currency suffers as foreigners exit European bond markets even as the ECB’s Asset Purchase Program helps keep yields artificially low. Negative rates -– whether nominal or real -– won’t attract net inflows to the region
  • And the political uncertainty slows business decisions meaning that sluggish growth won’t accelerate any time soon. That makes equities less appealing
  • Theoretically, Europe is set to avoid each of this year’s political pitfalls — but the scares will be genuine. The euro will continue to slide in line with the rising long- term risk-premium around the region, while the bond markets flare-ups will be acute ahead of specific dates
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