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Rates markets in Europe and UK volatile

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Interest rate markets in Europe and the UK have been particularly volatile – and generally trending higher - in recent weeks, owing to the most recent (and particularly closely-watched) ECB and BoE meetings, alongside inflation data in the UK.

The MPC saw an 8-1 rate vote at its latest meeting, with the dissenting member enough to push five-year swap rates higher by 4bps to 0.90%. Stronger-than-expected UK inflation data initially pressured gilts lower, with ten-year UK yields climbing by around 6bps and then selling off as the market expects the MPC to ‘look through’ current short-term inflation pressures partially caused by currency depreciation. The market jumped to price in almost one full hike by August 2018.

Meanwhile, in his March press conference, Mario Draghi declared victory over the deflation fears that prompted the ECB’s trillion-euro bond-buying spree two years ago. “There is no longer that sense of urgency in taking further actions while maintaining the accommodative monetary policy stance including the forward guidance,” he said. The probability of a December 2017 rate rise moved to over 50% from one tenth following the speech.

Alongside inflation prints and expectations, and the actions and mutterings of the ECB, political risk in the eurozone remains critical to the direction of markets, particularly in the wake of market underestimating and under-pricing event risks leading into Brexit and Trump victories. While one potentially major threat to the underlying political complex in the EU was sidestepped as Dutch anti-EU politician Geert Wilders failed to make a breakthrough in elections last Wednesday, investors’ attention now moves to the French presidential elections.

These are causing investors and financial market-makers considerable angst. Currency options prices indicate that investors are quite concerned about, and thereby pricing in, the idea that this single event could ultimately lead to the disintegration of the EU. Far-right candidate Marine Le Pen has promised the French electorate that she will reshape France’s relationship with the EU if she wins. This uncertainty is a major factor driving currency markets at present.

Implied volatility of currency options is a good example of market risk pertaining to a particular future event. The first round of the 2017 French presidential election will take place on 23 April. Should no candidate win a majority, a run-off election between the top two candidates will be held on 7 May. Polls currently indicate Ms Le Pen will lead in the first round, or come out level with the centrist former economy minister Emmanuel Macron. They then predict that she will be comfortably beaten in the run-off. Unsurprisingly, markets do not appear to trust the polls as much as perhaps they once used to. Despite the predicted defeat, currency options are pricing in the opposite possibility; the difference between one-month contracts, expiring before France's crucial second-round vote, and two-month options, by which time the winner will have been declared, can be used as a proxy for the importance this market is putting on the event. For euro-dollar options, the difference in option pricing was last week over 2.5 percentage points (in terms of applied volatility) – a five-year high – before narrowing slightly after Wilders lost in his election bid last Wednesday. What is clear is that investors have previously mispriced political event risk both in this election cycle and by populist voting in other countries, and seem determined not to be undone again.

Against this backdrop, any steer on the direction of the French victor will move markets. The first French presidential debate (there are another two debates to come prior to the first-round election) was reported as being won by centrist Emmanuel Macron. An Elabe poll surveying 1157 respondents found that Macron was seen as the winner at 29%, Melenchon second with 20%. Fillon and Le Pen came in joint third at 19% and Hamon came in fifth at 11%. As a result, the average probability of a Macron win implied from betting odds climbed 2pp to over 63%. It is worth remembering Hillary Clinton was seen as a comfortable winner in all US presidential debates, and was well ahead in almost all polls.

Such easing of concerns over France’s position in the eurozone pushed the euro to its strongest level in six weeks to over 1.0800 against the USD, while safe-haven German bonds slid at the open following this first debate. Correspondingly firmer rate hike expectations followed; Euribor market pricing now shows approximately 20bps of rate increases priced by Sept. 2018. No doubt any of these moves will be quickly undone should there be an uptick in Ms Le Pen’s Presidential bid. On the flip side, considering heightened investor fears over this election and the fact that the euro is historically cheap, if this political risk were to go away then there has to be potential for investors to flow into Europe

All views expressed here are the author’s own and are based on information available at the time of writing.

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