If you haven’t seen Scrooged, Bill Murray’s classic take on A Christmas Carol, then I feel sorry for you. You have missed out on one of life’s greatest joys.
The opening scene finds Murray (in the film he’s “Frank Cross”, an executive at a cable television network) screening a bloody trailer for a TV movie he plans on running over the holidays. Here’s the clip:
Subsequently, Eliot Loudermilk (the employee you see at the beginning of that clip played famously by Bobcat Goldthwait) objects. Here’s the exchange:
Eliot: Mr Cross, what exactly does that ad have to do with “Scrooge”?
Frank: Nothing. Why?
Eliot: You can’t show that commercial. If you run that… you’re gonna frighten people.
Frank: You think I’m off base?
Eliot: Well…a tad, sir. Um, that looked like the Manson Family Christmas Special.
Frank: Well, it’s a little late for this kind of feedback.
Eliot: That’s because it’s the first time I’ve seen it, sir.
That’s a little bit like what I’m about to show you from BofAML.
See the thing about the euro and the French elections is that while some measures of market angst are clearly flashing red, that probably reflects hedging of long positions.
You’ll see what I mean when you read the excerpts and check out the charts shown below. Unfortunately, as Bloomberg’s Mark Cudmore wrote on Friday, “you can enjoy most of your Sunday because there’s no market to react anyway.”
So ultimately, I’m like Frank and you’re like Eliot.
You: You can’t show those charts. If you run that… you’re gonna frighten people.
Heisenberg: You think these charts show the market is off base?
You: Well… a tad, sir.
Heisenberg: Well, it’s a little late for this kind of feedback.
You: That’s because it’s the first time I’ve seen it, sir.
Market underpricing risks.
Few days ahead of the French elections, almost anything is possible based on the polls. The worst outcome for markets is if Le Pen and Melenchon are in the 2nd round, in our view, as markets could start pricing Frexit risks. Markets could also react negatively to a Fillon and Melenchon 2nd round, as the polls suggest Melenchon could win. Markets are still underpricing the risks, in our view. Although sharp moves in EUR risk reversals reflect strong recent demand for hedging, investors remain long European assets and long EUR. We see asymmetric EUR risks from the elections, with EUR/USD at 1.10 in a positive scenario, but below parity and as low as 0.90 in a negative scenario. We have been more concerned than the consensus about the French elections, but our baseline remains optimistic. We have closed our year-ahead contrarian short EUR/GBP trade. We remain long EUR/CHF, expecting France to avoid extreme scenarios.
Tail risks have increased
Few days ahead of the first round of the French elections, Macron, Le Pen, Fillon and Melenchon are within the margin of error in the polls. We have been arguing that risks from the French elections could increase closer to the event, as polls could converge and tail risks could become more likely. At this point, there are six possible combinations on who could make it to the second round, all almost equally likely according to the polls. The share of undecided voters remains very high, which could also lead to surprises.
The worst outcome for markets from the first round is if Le Pen and Melenchon make it to the second round, in our view. We have already argued that markets would price immediately Eurozone breakup risks if Le Pen was to win the second round. Even though getting agreement on a formal referendum on Euro membership in France will be difficult for Le Pen, we believe markets will see the French elections as effectively the referendum and would start pricing Frexit risks. France and the rest of the Eurozone could reach the point of no-return well before a referendum in France. Although markets could give Melenchon the benefit of the doubt, they could soon realize that his policies are inconsistent with participation in the Eurozone and could eventually also start pricing Frexit risks. A choice between Le Pen and Melenchon will be a choice between two extremes that could lead to the same outcome, Frexit and a breakup of the Eurozone. In this context, Macron or Fillon will be the market-friendly outcomes, at least in the short term—both could face challenges achieving a consensus for the reforms that the French economy needs. We note that markets could also react negatively to a second round between Fillon and Melenchon, as the polls suggest Melenchon could win.
Markets unprepared for the worst
Markets are still underpricing the risks from the French elections, in our view. True, EUR/USD and EUR/CHF short-term risk reversals are at historically low levels (Chart 1 and Chart 2). However, this reflects hedging of long positions. Our Global Fund Managers Survey shows the Eurozone as the most favored region for equity investors. The EPFR flows show strong demand for Eurozone equities this year (Chart 3). Our positioning analysis shows both real money and hedge funds long EUR for the year (Chart 4). Both started selling EUR only last week, most likely because of concerns about the elections in France as polls converged. EUR is the second longest G10 FX position for the past 12 months, according to our positioning measures—after JPY (Chart 5). The reason EUR/USD has not done much this year is selling by corporates and officials, offsetting buying by real money and hedge. Our Rates and FX Sentiment survey suggests that investors are still short EUR, but far from the stretched levels during 2014-15. Our quant models suggest that the option market is behaving as if it is still long EUR/USD, reflecting strong recent demand for hedging. The CFTC data show the market’s EUR/USD position flat, far from the short positions in recent years (Chart 6).
We see asymmetric EUR risks from the French elections. Although we have been flagging positive EUR risks from ECB QE tapering later in the year, this has now become the consensus. Data and fundamentals could support a slightly stronger Euro, but not by much, as long as Fed and ECB monetary policies diverge. We can see EUR/USD at 1.10 if Macron or Fillon wins, but not a sustained move much higher. In contrast, we have argued that the Euro could see a Brexit move if Le Pen was to win, suggesting EUR/USD well below parity, and as low as 0.90, soon after the second round. We would also expect a sharp move for EUR/USD lower if Melenchon was to win, although less and slower than in a Le Pen scenario and closer to parity. A move towards parity after a negative result from the first round would be consistent based on what risk reversals are currently pricing (Chart of the Day).