EUR: Guided by the political risks – RBC CM

Elsa Lignos, Research Analyst at RBC Capital Markets, suggests that the evolving political risks in the Eurozone are expected to guide the EUR trajectory in the near term.

Key Quotes

“There is not much new to say on European elections. France is still the focus point (April 23 & May 7). Le Pen is expected to win the first round though polls point to her struggling in the second. Markets are less convinced than the pollsters. Having been burnt by the US election and UK referendum, both bookies’ odds and EUR vol are pricing in a significant chance of a Le Pen victory (~25% on Betfair odds, though note the odds quoted by Bloomberg overstate Le Pen’s probability by 5-7%).”

“Markets were overpricing Le Pen’s chances of victory (though that has come down in the last week) but underestimating how damaging it would be to EUR if she were to win. Using our synthetic-EUR framework, we estimate EUR/USD could trade as low as 0.70 if France were to hold a referendum on EUR membership. French voters tend to support the EU/EUR but the probability of voting to leave conditional on Le Pen having won the election is a lot higher.”

“Support is not high enough to guarantee the outcome of a referendum and while it may be unconstitutional to pose the question without National Assembly support, there is precedent for that dating back to De Gaulle. Political risk does not go away after the French election either. The German election is much less likely to lead to dramatic currency outcomes but Italian political risk is not going away any time soon.” 

“6-12 Month Outlook – Careful what you wish for

Beyond elections, focus is on the ECB. Headline inflation continues to rise (hitting 2% for the first time since 2013 on the Feb flash estimate). But core inflation is still below 1%y/y. That should give the ECB cover to extend its asset purchase programme into 2018, albeit at a slower pace. Drilling into the country detail, Germany is contributing up to 40% of the Euro area’s core inflation, while Italy’s contribution remains particularly weak relative to its size (~10%). In many ways, the ECB’s greatest problems will come when it starts hitting its inflation target. Underneath the convergence brought about by QE, the problem of fragmentation persists across the Euro area. We expect that to keep the ECB in easy policy mode for longer than would otherwise be expected, and we stand by our call for EUR/USD to drift lower through 2017.”