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French elections is priced more appropriately in bonds (but not in currencies) than going into the Brexit and US vote.
In the remote scenario of a Le Pen Presidency with supportive government and Parliament, 10Y Bunds could approach 0bp and 10Y France-Germany 200bp, with sharply wider Bund swap spreads (54bp), FRA/OIS (20bp) and EUR/USD cross currency basis (-60bp), and higher volatility (Bund implied 6bp/day).
Less extreme scenarios of Le Pen Presidency but cohabitation or extreme left Presidency would likely result in considerably less extreme outcomes.
We reduce but still keep a France underweight in cash, but find better risk reward in Spain UW, highlight attractive levels on 5Y France CDS, selling high-coupon OATs vs. low-coupon ones.
Summarizing across the scenarios and our projections, we believe widener in swap spreads, FRA/OIS and EURUSD cross currency basis and long volatility will offer the most attractive hedge for the scenario of a Le Pen Presidency with supportive government and Parliament.
However, given the limited probability but large impact of the tail risk we recommend building exposure either via conditional structures or where the risk/reward appear asymmetric relative to our baseline scenario.
In swap spread we find it attractive to implement Bund bull swap spread widener. Given limited liquidity in the Jun 17 options (expiry on 26th May) we recommend investors to hold position on the longest maturity available in OTM structures but roll them further out.
Ideally, the Jun 17 options (expiring on 26th May 2016) would be the preferred expiry given the calendar of election (first round on 23rd April and second round on 7th May). From a trade point of view, we recommend buying the 161/163 Apr17 Bund call spread versus selling a maturity matched receiver spread.
Our preference towards implementing this trade via call spread reflects the fact that the options market is already pricing too high swap spread directionality for deeper OTM options (the 163 calls are pricing swap spread directionality in excess of 50%.
