The first round results of the French election threw the market no surprises. Emmanuel Macron has come first and Marine Le Pen has come second in round one of the two-part Presidential election. But as Ms Le Pen has a 25% or so polling deficit to Mr Macron for the second round in two weeks’ time (which is more than three times the typical margin of error) the market will likely fully price in the outcome of the second round today in favour of Mr Macron.

This matters as the market has embedded a risk premium in both EUR and OATs for some time now heading into this election. We expect that premium to nearly completely come out of the market pricing and this should see EUR/USD finish above 1.09 on the day and we expect this to continue and are entering a long EUR/USD position. We interpret the outcome as market positive and expect 10yr Bunds to sell off at least ~5bp, while OATs should rally ~10bp, leading to tighter spreads. If Mr Macron wins in line with expectations we think 10yr OATs will rally a further ~15bp.

Who is likely to win the second round?

As it stands, second-round polling would say with a high conviction that Mr Macron will win. We agree as it would require a large error in the polls at this stage and this is why we have been focused primarily on the first round. At this stage, we expect the market to near fully price in this outcome and the second round could prove to be a non-event for markets. In politics though, one can never rule anything out completely, and we have noticed a previous pattern in second- round polling that is worth keeping an eye on.

The fundamental picture for the EUR is clearly for upside

Positive fundamentals continue to underpin the EUR. Since mid-2014 the eurozone economy’s slack has been reduced at a significantly faster rate than that of the US. These developments have not yet been reflected in ECB policy, government bond yields or the EUR. We do not believe this divergence can last indefinitely and therefore see a high risk that the ECB will be more hawkish than expected in coming months and quarters, particularly given our above-consensus forecasts for growth and inflation.

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We expect the ECB to signal its intention to taper QE purchases at the September meeting with the move starting from January 2018. This would be EUR positive, and potentially in a non-linear fashion, as the ECB exits the ZLB. A key debate has been whether rate hikes can come before the end of QE. This scenario would be more EUR positive than the Fed-style normalisation process, which is one reason why this exit strategy may be problematic for the ECB. While we expect tapering before a rate hike, the risk of this scenario cannot be ruled out, and points to EUR upside risks. It is one of several reasons why we expect EUR/USD to test 1.15 by year-end.

So if the ECB tapers and the EUR curve bear steepens, JPY would be the clear underperformer, while an early rate hike would likely weaken USD, GBP and CAD more. However, any risk of a full “taper tantrum” may be a bit of a stretch given ECB tapering will be less negative for high- yielding G10 and EM currencies than rate hikes, and the smaller increase in exposure to these bond markets will likely limit the mid-term impact of ECB QE on them too. These currencies’ reactions will still depend more on risk sentiment though, and ECB communications ahead of likely normalisation will be crucial.

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