Screaming and Shouting

I’ve always liked the occasional bet. This is a facet of my personality that I suppose came in useful in the old days when my day job was risking money, or managing people who were risking money.  Thinking like a trader is a hard habit to break and my thoughts have recently been turning to the French election.

First up, let me say that last year was a good one for me on the betting front. In football, I backed Leicester to win the Premiership. Not at the extravagant 5000-1 odds that a lucky few obtained, but at a more reasonable 18-1 in late 2015 when the un-fancied team was four points clear at the top of the table. My thinking? It was a four horse race with the leading horse at very long odds. What was the worst that could happen?

Then there was Brexit. I confess that I backed Leave heavily, not particularly because I thought it would happen, but rather as a hedge: emotional and financial. 5-1 against in a two horse race with polls almost tied seemed decent odds. Last, for similar reasons, I bet on Trump. For the record, this is a bet I heartily wish I had not won.

All these events had one thing in common. Conventional wisdom said they would not – could not – happen, despite evidence to the contrary: Leicester’s continuing form; Brexit polling; Trump’s electoral momentum.

Which brings me to France. French friends of mine tell me Marine Le Pen cannot win in May. She’ll probably reach the second – deciding – round, but cannot win in that. I continue to read similarly comforting opinions in the papers: there is a natural blocking vote against her. I once read similar things about Trump. He had offended women, liberals, blacks, Hispanics, you name it; who was left to vote for him? We all know what happened.

To some extent the betting markets back this up. Le Pen is not the favourite. As I write this, the odds against her winning are 2-1 against. Macron is ahead, the controversial-wife-employing Fillon is 5-2, and all other candidates are now long odds outsiders. But her odds have been steadily tightening. And consider the implications of those 2-1 odds. It means the betting markets think there is roughly a 30% chance of her winning. I would not like to go into surgery with a 30% chance of disaster.

And disaster is what could be in store. I won’t comment about the FN’s policies towards refugees and immigrants. Suffice it to say that my father was both a refugee (escaping on foot as a ten-year-old child from war-torn Burma) and, later, an immigrant to the UK. Rather, if the rhetoric about protectionism, nationalism and the virulently anti-EU tone was converted into action there would be chaos. The prospect of France leaving the EU via a promised referendum – unlikely though it seems – would be Brexit times ten. It is one thing for the EU to lose a semi-detached, rather unenthusiastic member. To lose a founding member would be catastrophic. Even the possibility of this occurring would be destabilising in the extreme.

Then there is the talk of France exiting the Euro and reintroducing the Franc. In 2012, at the peak of the crisis in Cyprus, I ran a series of ‘war games’ looking at what Deutsche Bank (my then employer) would need to do in the event of capital controls being introduced within the Eurozone. We rapidly came to the conclusion that the Eurozone would – in effect – break up into country-sized chunks. What would result from the rapidly escalating blocks on flows would be ‘German Euros’, ‘French Euros’ and the like. It would mean the end of the Euro and financial carnage. The ‘Draghi put’ later that year meant that we put the results of these war games into a folder with a sincere hope never to look at them again.

If France really were to go for the Franc, the mess would make Cyprus look like child’s play. Would France redenominate its bonds and, if it did, would that be a default (S&P say ‘yes’)? What is certain is that there would be mass capital flight and, almost certainly, given the still-opaque nature of risks within the fragile European banking sector, another banking crisis. In the long run maybe things would be fine (my own view is that the Euro in its current form has been a terrible error) but, as Keynes remarked, in the long run we are all dead. In the short term there would be immense pain.

So what to do?   In my heart, I still think my French friends are right and the country will see sense. I also can’t think that 2-1 in a three-horse race is sufficiently long odds for Le Pen to be worth the Brexit/Trump bet (where odds were as long as 5-1 in a head-to-head). But are there things to do in financial markets?

At the risk of making any ex-colleague of mine shake his or her head with weary memories of similar enthusiasms, I would buy EURUSD volatility here.   The currency pair has been in quite a tight range for a while and short-dated options reflect that. Vols of 6-8% are in line with the current stasis. For longer tenors the implied volatility rises (as one would expect) with a very pronounced jump into the French election period: 3 month options trade at about 10%. But so do one-year options. Now, just to put that in historical perspective, back in the Great Financial Crisis one-year EURUSD vols reached high teens. Even in 2012 they got to 15-16%. Would the election of Le Pen (a 30% chance) lead to a crisis as bad as these? In my view, definitely yes. Besides, the average this century has been above 10% – if Le Pen loses, you’d have plenty of time to stop out.

I am a little bit of a broken record on this subject but if there is one thing that I have learned from past crises it is that options markets always underestimate the severity of the storm to come. I have seen this from the ERM in 1992-93 all the way to 2007-08. And the other thing we all should have learned last year was that contemplating the unthinkable should be second nature.

So be prepared.