Is Another “Whatever It Takes” Moment Just Around The Corner?

With the euro (somewhat perversely) heading for its second week of gains versus the dollar and its biggest in three months, there’s probably no better time to ask the following: “what happens in the event ‘Frexit’ risk rises?”

As we and every other commentator have made clear over the past month or so, Le Pen isn’t the only risk here. And indeed, if one of the mainstream candidates does win, it could serve to strengthen the National Front over the long-run if either Macron or Fillon prove unable to, as one official told Politico this week, “break the paralysis and curb high unemployment.”

To quote Bloomberg’s Richard Breslow, “unless the politicians manage to implement the structural changes needed to alleviate the insecurities of their fellow countrymen, this is going to be a problem in remission only [which means you should] be wary next week of people who tell you, ‘well that’s, that.'”

Well, with the whole world watching and with multiple measures of market nervousness still flashing red…

… this is probably a good time to present the following from Goldman who was out Thursday evening asking what the future holds for the common currency under a variety of possible electoral outcomes.

Via Goldman

We provide a framework to forecast possible moves in the Euro depending on changes to the probability that investors assign to: (1) Ms. Le Pen becoming the next French President; (2) a break-up of the Euro area; and (3) a ‘flight to safety’ regime triggered by the French election result. While these three events are positively correlated, they are also distinct. For example, in the event that Ms. Le Pen does not qualify for the second round of the French elections, investors are unlikely to completely price out Euro area break-up risk given the rise of Euro-sceptic parties in other members of the monetary union.

To preview our results, our analysis suggests that an increase in the probability that investors assign to a break-up of the Euro area which is close to its peak in July 2012 could push the EUR about 5% lower versus the USD and the JPY, effectively taking EUR/USD close to parity. Conversely, should Ms. Le Pen fail to make it to the second round, EUR/USD could trade around 1.13 (from the current level of 1.0770).

We use a simple framework to estimate the betas of a change in the EUR nominal exchange rate versus all G-10 currencies, as well as the currencies of Poland, Hungary, the Czech Republic and Romania, to changes in three different indicators of Euro area break-up risk. The indicators are: first, a variable that measures the probability of Ms. Le Pen being elected President, based on bookmaker quotes. This series is available on Bloomberg at a daily frequency since 20 January 2017 and shows a tight negative correlation with EUR/USD (see Exhibit 1).

Second, the Euro area Sentix index, a survey-based measure, available at monthly frequency since June 2012, which measures the probability that investors assign to a break-up of the Euro area. This index is currently at 19%, having peaked at 73% in July 2012, before Mr. Draghi’s “whatever it takes” speech lowered the EUR convertibility risk, taking the index to its lows (7%) in July 2014.

Third, a variable, captured at daily frequency and estimated by our European economists, which indicates whether or not markets are pricing a ‘flight to safety’ regime. In each specification, we control for the change in interest rate differentials between the two currencies (measured by 2-year swap rate differentials). We also run robustness checks by adding controls for changes in oil prices, changes in the VIX and our proprietary economic data surprise indices.

3. Using the first indicator (i.e., the odds of Ms. Le Pen being elected President), we quantify the impact of a 10pp increase in the odds of a Le Pen presidency on the various Euro crosses (Exhibit 2). This exercise is particularly useful as it gives us a sense of the market impact should Ms. Le Pen get a higher vote share in the first round than currently indicated by polls (say greater than 30%, compared with the low 20% that polls currently suggest). Our framework implies that, among the G-10 crosses, EUR/USD would fall the most (about 2%) and EUR/NOK the least (about 0.5%), while EUR/SEK would show a slight appreciation.

Conversely, should Ms. Le Pen fail to make it to the second round (which would lead to a decline in the odds of her being elected to 0, from the current level of 23), EUR/USD could appreciate by around 5%, reaching around 1.13 (from the current level of 1.0770).

[…]

5. The probability that investors assign to a break-up of the Euro area (as captured by the Sentix index) has declined from 25% in February to 18% in March — a period over which the odds of a Le Pen presidency have declined from around 35% to 25%. If both the centrist candidates make it into the second round, which in our view would be the most market-friendly outcome, it is unlikely that the probability of Euro area break-up would fall to 0, given that populist, Euro-sceptic movements in other countries (Italy in particular) would still pose a threat to the currency union. This could effectively cap any gains in the Euro from the perspective of a lowering in Euro area break-up risk after the French election.

However, a strong endorsement of Ms. Le Pen in the first round would likely lead investors to reassess Euro break-up risk to the upside. We would expect such a revision to be very sizeable and persistent if the odds of her presidency increase beyond 50%, and if she makes a referendum to pull France out of the currency union a central point of her campaign between the first and second rounds — a dynamic that would clearly increase downside risks for the Euro.

6. To gauge how an increase in Euro area break-up risk maps onto moves in the Euro, we estimate the betas of different EUR crosses to changes in the Sentix indicator that measures the probability that investors assign to a break-up of the Euro area over the next 12 months. On our estimates, should this probability increase from the current 19% level to 73% (the level in July 2012 before Mr. Draghi’s “whatever it takes” speech lowered the convertibility risk priced in the EUR), EUR/USD could depreciate by about 5% and trade close to 1.02, EUR/JPY could move to 111.5 and EUR/GBP to 0.82, from current levels. We think that the risk to these estimates could be to the downside, although admittedly in a very negative risk environment the response of the ECB will be key, particularly to determine the persistence of the negative shock.If markets turn more negative on the possibility of deposit flights out of the French banking system or on Italian BTPs and banks, the currency can fall more in the absence of a decisive response from the ECB. But, if the ECB were to show a strong hand in the market, buying sovereign debt, this perception could change. Our European Economists do not expect the ECB to be constrained in taking more unconventional policy measures (if needed) between the first and second rounds of the French elections.

Conversely, a reduction in break-up risk to 10% would lead to a slight appreciation of the EUR versus the major G-10 currencies.

[…]

8. In summary, our analysis suggests that an increase in the probability that investors assign to a break-up of the Euro area that is close to its peak in July 2012 could push the EUR about 5% lower versus the USD and the JPY, effectively pushing EUR/USD close to parity. The potential upside following a market friendly outcome of the French election would likely be much smaller given the market’s benign pricing of Euro area break-up risk currently, and given little evidence that we are in a ‘flight to safety’ regime, which would be the case should Ms. Le Pen win the French elections. That said, how negative and persistent the market reaction will be also depends on the policy response, which, however, is unlikely to be as straightforward as in the aftermath of the Brexit vote, when the ECB supported Italian and Spanish spreads by buying more sovereign bonds.

Probably the most important thing you can take from all of that is simply this: if the risk of a eurozone break-up rises to 2012 levels, it will again be left to Mario Draghi to save the day.

Only this time around, “whatever it takes” might not be enough.