The French Revolution, Part Deux – Seeking Alpha

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Last weekend was a nervous time around the world as all attention focused on the Korean Peninsula and the potential for an escalation of a tense situation that has been firmly in place since the end of the war in the 1950s. The U.S. Administration and the North Korean leadership exchanged barbs and flexed their respective muscles. The weekend ended with the failure of a missile test in what is a building crisis and hope that Chinese involvement will defuse the potential for armed conflict.

Next weekend the focus will shift to France and its hotly contested Presidential election. The election comes at a time when many issues face the European nation. Polls are neck and neck leading into the weekend but as we learned in 2016, putting too much stock in polls could be a huge mistake. The French election comes at a time when economic conditions remain problematic as the wave of European Union sanctioned immigration from North Africa and the Middle East has diluted the French and European economies. Moreover, terrorist attacks by radical Islamic elements have resulted in a growing nationalistic fervor and support for the far-right candidate Marine Le Pen who is currently close to the top of the heap when it comes to pre-election polls.

The result of the April 23 election could have a significant impact on foreign exchange markets. The extent of that impact will come down to if the French choose to embrace or reject the status quo.

The next test in rejecting the status quo

The Brexit referendum in June 2016 shocked markets. A slim majority of the citizens of the United Kingdom stood up and voted against a future of policy decisions made in Brussels and Frankfurt. It was likely that waves of immigrants under the encouragement of the E.U. tilted the vote towards a rejection of the status quo and an embrace of sovereignty.

In November 2016, the election of Donald J. Trump as the forty-fifth President of the United States shocked the world as it was another, perhaps more stark, rejection of the status quo political environment. President Trump ran on a populist platform where he pledged to put America first. Both the U.K. and the U.S. voted for an about-face in their political paths over the past eight months. Now, the French election could stand as a continuation of that trend or a sign that Europe will dig in their heels and stay on the present course. On April 23, France will vote, and the results will be heard around the world. While then results of the Brexit referendum and U.S. election were immediate, the French outcome could take some time as the top two candidates in the election will likely face off in a runoff election in May adding another element of drama and volatility to the process.

A runoff will likely follow the election

The chances are that Marine Le Pen will be one of the two candidates who meet in May to determine the future political path of France. Le Pen is the nationalist and anti-Europe candidate. There is a lot of controversy surrounding Le Pen; her family has been on the fringe of French politics for decades. However, the Le Pen message that has been in the minority for many years has gained support because of economic stress, immigration, and the growing number of terrorist attacks. The pollsters have put the chances of her finish in the top two and a runoff as high, but few have given the far-right candidate a chance at winning the overall election in May. However, those same polls said that the U.K. would remain a part of the E.U. and that Hillary Clinton would easily defeat Donald Trump in last year’s U.S. Presidential election.

European economy is improving, but ECB is on hold

Recent comments by European Central Bank President Mario Draghi struck a positive tone about the economy. In late February Draghi told markets that Europe had successfully fought off deflationary pressures and that economic conditions were improving. However, the central bank chief did not raise interest rates from the current level of negative forty basis points, nor did he state that the program of quantitative easing would end or begin to taper before the end of 2017. The pause in monetary policy in Europe was likely a calculated decision to await the results of elections in an environment where Brexit and President Trump’s election has created a trend that could threaten the future of the Union of European nations.

The future of the E.U. and euro currency could hang in the balance

Three elections were on the schedule for 2017; the first has already taken place. The citizens of the Netherlands voted to retain the status quo and defeated a nationalist surge from the right. However, the actual test for the future of Europe will come from elections in the two major economic forces within the Union, France first and then Germany.

If the status quo loses one of the two remaining elections in 2017, it could spell disaster for the European Union which is now negotiating with the U.K. the terms of their departure. The departure of France or Germany would continue a trend that will pick up a head of steam and threaten the ability of the remaining nations in the Union to govern. The euro currency would likely plunge in the wake of a French or German election surprise. However, the euro should rally if the status quo in both countries prevails. Source: CQG

As the monthly chart of the euro versus U.S. dollar relationship highlights, the euro has been moving lower, making lower highs and lower lows, since July 2008 when it traded at $1.5988. The most recent low in the euro came in early January 2017 at $1.03675 in December 2016. The foreign exchange rate is going into the French election at under the $1.07 level which is not far from the lows. If Marine Le Pen makes it to a runoff election, we will likely see pressure on the euro. If she fails to finish in one of the top two spots, the euro could reflect improving conditions that ECB President Draghi has alluded to in his recent comments. After France, Germany will go to the polls to decide if the country will give Angela Merkel a fourth term as Chancellor of the nation with the strongest economy in Europe. There is more of a chance of political change in France than Germany, but given the events of 2016, nothing is a certainty at this point. Additionally, with the constant threat of terrorism in Europe, events that transpire over coming weeks and months could influence the outcome of the German election.

Volatility in currency markets on the horizon

The U.S. dollar and the euro currencies are the two dominant reserve currencies in the world. Reserve currencies tend to exhibit stability, and that is why central banks favor holding them as reserve assets in their foreign exchange holdings. Governments all over the world hold dollars and euros more than any of the other world currencies. However, a surprise in the French or German elections, which would not come as so much of a surprise anymore in the wake of Brexit and President Trump’s victories, will change the status of the euro on the world scene.

I expect that if candidate Le Pen has a strong showing this coming Sunday, we could see some tremendous volatility in the currency markets. The euro currency is likely to challenge parity against the dollar, a level not seen since 2002. A first or second place finish for the nationalist candidate would amount to a French Revolution part Deux, and a tidal wave of fear will sweep from Brussels to Frankfurt as well as around the world. On the other hand, a defeat could ignite a rally that puts the euro at 1.10 or higher against the dollar. Therefore, the euro-dollar relationship will not stay where it is for long, and there is lots of volatility on the horizon. Moreover, Italy looks like the next financial nightmare for the E.U. and the French voters may choose not to be in a position where they must underwrite another E.U. bailout. The ramifications of the French election are enormous, and it will set the stage for the future of Europe even more than the German vote.

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I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.