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Goldman Sachs FX Views The Euro & Frexit Risks

1. Since the beginning of the year, news around the French elections has driven the Euro as polls turned more favourable to Ms. Le Pen or, more recently, became less indicative of a possible victory for one of the two mainstream candidates (Mr. Macron or Mr. Fillon). The market focus is now on the risk that France could leave the Euro area if Ms. Le Pen becomes the next President of France. However, given the uncertainty around the outcomes of the first and second round votes, and
considering that a ‘Frexit’ would be a tall order even under a Le Pen presidency , it is useful to assess how much the Euro could depreciate or appreciate under different scenarios.

In particular, in this FX Views, we provide a framework to forecast possible moves in the Euro depending on changes to the probability that investors assign to: (1) Ms. Le Pen becoming the next French President; (2) a break-up of the Euro area; and (3) a ‘flight to safety’ regime triggered by the French election result. While these three events are positively correlated, they are also distinct. For example, in the event that Ms. Le Pen does not qualify for the second round of the French elections, investors are unlikely to completely price out Euro area break-up risk given the rise of Euro-sceptic parties in other members of the monetary union.

To preview our results, our analysis suggests that an increase in the probability that investors assign to a break-up of the Euro area which is close to its peak in July 2012 could push the EUR about 5% lower versus the USD and the JPY, effectively taking EUR/USD close to parity. Conversely, should Ms. Le Pen fail to make it to the second round, EUR/USD could trade around 1.13 (from the current level of 1.0770).

2. We use a simple framework to estimate the betas of a change in the EUR nominal exchange rate versus all G-10 currencies, as well as the currencies of Poland, Hungary, the Czech Republic and Romania, to changes in three different indicators of Euro area break-up risk. The indicators are: first, a variable that measures the probability of Ms. Le Pen being elected President, based on bookmaker quotes. This series is available on Bloomberg at a daily frequency since 20 January 2017 and shows a tight negative correlation with EUR/USD (see Exhibit 1).

Second, the Euro area Sentix index, a survey-based measure, available at monthly frequency since June 2012, which measures the probability that investors assign to a break-up of the Euro area. This index is currently at 19%, having peaked at 73% in July 2012, before Mr. Draghi’s “whatever it takes” speech lowered the EUR convertibility risk, taking the index to its lows (7%) in July 2014.
Third, a variable, captured at daily frequency and estimated by our European economists , which indicates whether or not markets are pricing a ‘flight to safety’ regime.
In each specification, we control for the change in interest rate differentials between the two currencies (measured by 2-year swap rate differentials). We also run robustness checks by adding controls for changes in oil prices, changes in the VIX and our proprietary economic data surprise indices.

3. Using the first indicator (i.e., the odds of Ms. Le Pen being elected President), we quantify the impact of a 10pp increase in the odds of a Le Pen presidency on the various Euro crosses (Exhibit 2). This exercise is particularly useful as it gives us a sense of the market impact should Ms. Le Pen get a higher vote share in the first round than currently indicated by polls (say greater than 30%, compared with the low 20% that polls currently suggest). Our framework implies that, among the G-10 crosses, EUR/USD would fall the most (about 2%) and EUR/NOK the least (about 0.5%), while EUR/SEK would show a slight appreciation.

Conversely, should Ms. Le Pen fail to make it to the second round (which would lead to a decline in the odds of her being elected to 0, from the current level of 23), EUR/USD could appreciate by around 5%, reaching around 1.13 (from the current level of 1.0770).
We do not find any statistically significant effect of a change in the odds of a Le Pen presidency on the EUR/CEE crosses (HUF, PLN, RON, CZK), with the estimated betas being very small.
4. While our results may seem intuitive in terms of the direction and relative magnitude of currency moves under the various possible outcomes of the first round vote, there are reasons to caveat these estimates. First, the probability variable is available only from 20 January 2017, which means the coefficients are estimated over a small sample. Second, these coefficients may under- or overestimate moves in the crosses we consider because the mapping from the odds variable to the probability of a break-up

will likely be non-linear. Hence, the EUR can move by more or less than indicated in Exhibit 2 depending on how investors reprice the risk of a break-up of the Euro area following the vote (see below for further discussion of this).

5. The probability that investors assign to a break-up of the Euro area (as captured by the Sentix index) has declined from 25% in February to 18% in March – a period over which the odds of a Le Pen presidency have declined from around 35% to 25%. If both the centrist candidates make it into the second round, which in our view would be the most market-friendly outcome, it is unlikely that the probability of Euro area break-up would fall to 0, given that populist, Euro-sceptic movements in other countries (Italy in particular) would still pose a threat to the currency union. This could effectively cap any gains in the Euro from the perspective of a lowering in Euro area break-up risk after the French election.

However, a strong endorsement of Ms. Le Pen in the first round would likely lead investors to reassess Euro break-up risk to the upside. We would expect such a revision to be very sizeable and persistent if the odds of her presidency increase beyond 50%, and if she makes a referendum to pull France out of the currency union a central point of her campaign between the first and second rounds – a dynamic that would clearly increase downside risks for the Euro.

6. To gauge how an increase in Euro area break-up risk maps onto moves in the Euro,
we estimate the betas of different EUR crosses to changes in the Sentix indicator that measures the probability that investors assign to a break-up of the Euro area over the next 12 months. On our estimates, should this probability increase from the current 19% level to 73% (the level in July 2012 before Mr. Draghi’s “whatever it takes” speech lowered the convertibility risk priced in the EUR), EUR/USD could depreciate by about 5% and trade close to 1.02, EUR/JPY could move to 111.5 and EUR/GBP to 0.82, from current levels. We think that the risk to these estimates could be to the downside, although admittedly in a very negative risk environment the response of the ECB will be key, particularly to determine the persistence of the negative shock. If markets turn more negative on the possibility of deposit flights out of the French banking system or on Italian BTPs and banks, the currency can fall more in the absence of a decisive
response from the ECB. But, if the ECB were to show a strong hand in the market, buying sovereign debt, this perception could change. Our European Economists do not expect the ECB to be constrained in taking more unconventional policy measures (if
needed) between the first and second rounds of the French elections

Conversely, a reduction in break-up risk to 10% would lead to a slight appreciation of the EUR versus the major G-10 currencies. Once again, we do not find any statistically significant effect on the EUR/CEE crosses (HUF, PLN, RON, CZK), with the estimated betas being very small. This may simply reflect the close ties of these economies to the Euro area and the fact that CEE central banks have adjusted policy in the past to prevent sharp changes in their currencies.


7. Finally, our measure of the probability of a ‘macro flight to safety’ (FTS) event in the Euro area currently stands at 0.6%. This low level implies an asymmetric bias for the EUR around the French election. On a market friendly outcome in the first round, the FTS indicator is likely to remain below 1%, and there would be no impact of flight to safety dynamics on the EUR. However, in the event of an unfavourable outcome, we estimate that the EUR would depreciate by between -0.13% and -0.24% against safe-haven currencies (USD, JPY and CHF) for each 10pp increase in the likelihood of a Euro area ‘flight to safety’.

If a victory for Ms. Le Pen were large enough to trigger a definitive ‘flight to safety’ event in France (i.e., an increase in the probability of entering an FTS from 0.6% to 100%), the EUR could depreciate by -1.2% against USD, -1.1% against CHF and -2.2%
against JPY (over and above the effects captured by changes in interest rate differentials) based on this framework. Indeed, these effects are smaller than our estimates under the previous two indicators: election probabilities and the Sentix index.
One possible explanation is that the two variables (the Sentix Index and FTS) measure different risks. Indeed, the correlation between the monthly average of the flight to safety indicator and the Sentix index is just 14% over the sample starting in June 2012 and there are several periods (including this year) when the Sentix index has increased substantially but the FTS index has not, and vice versa.

8. In summary, our analysis suggests that an increase in the probability that investors assign to a break-up of the Euro area that is close to its peak in July 2012 could push the EUR about 5% lower versus the USD and the JPY, effectively pushing EUR/USD close
to parity. The potential upside following a market friendly outcome of the French electionwould likely be much smaller given the market’s benign pricing of Euro area break-up risk currently, and given little evidence that we are in a ‘flight to safety’ regime, which
would be the case should Ms. Le Pen win the French elections. That said, how negative and persistent the market reaction will be also depends on the policy response, which, however, is unlikely to be as straightforward as in the aftermath of the Brexit vote, when the ECB supported Italian and Spanish spreads by buying more sovereign bonds. This time, the political constraints posed by France leaving the Euro area could also constrain the ECB, as some members of the Monetary Union will likely be concerned about Target 2 imbalances in a scenario in which a break-up of the Euro area becomes a realistic threat.


Marketing communication : This document has not been developed in accordance with legal requirements designed to promote the independence of investment research and its author(s) is/are not subject to any prohibition on dealing in the relevant financial instrument ahead of the dissemination of the marketing communication.

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