EUR Stability Amidst Uncertainty Following French Elections

The recent French parliamentary elections have introduced a period of uncertainty, yet the risk of extreme market volatility seems to have diminished. Markets have responded mildly to the election outcomes, maintaining relative stability as the process of forming a new government begins. Historical precedents from other euro-zone countries indicate that coalition negotiations can be lengthy. For instance, Belgium set a record with 592 days to form a government in 2020, and it took 541 days in 2010. The Netherlands also experienced prolonged negotiations, taking nearly nine months to finalize a government in December 2021. These extended periods are common, but due to the significance of France's economy, prolonged instability could have broader implications. However, President Macron's decision to temporarily retain Prime Minister Attal aims to maintain stability during these negotiations.

 Source: BloombergFollowing the election results, the EUR/USD exchange rate showed little change, and the spread between French OATs and German Bunds narrowed slightly by 2 basis points. A key factor contributing to market stability is that President Macron’s Ensemble performed better than expected despite his low popularity. Ensemble remains the largest established political party in parliament, providing Macron with a stronger position during negotiations.

The New Popular Front (NPF), a coalition of left-leaning parties with no prior history of collaboration, faces potential internal challenges. Jean-Luc Mélenchon’s Unbowed party, the most divisive within NPF, secured the highest number of seats (71), followed by Raphael Glucksman's Socialists with 64 seats. The inherent differences within NPF could lead to fractures, possibly paving the way for a left/centrist coalition. Such developments could alleviate concerns of anti-European sentiment and inward-looking policies, presenting a more favorable scenario for France.

The EUR/USD exchange rate appears to be increasingly influenced by interest rate spreads, with the narrowing of the 2-year Eurozone-US swap spread aligning with a stronger EUR/USD. The reduction in US yields has also contributed to this trend. 

Additionally, the relative macroeconomic indicators, as measured by the Economic Surprise indices for the Eurozone and the US, are the most favourable for the Eurozone since 2021. While a slight risk premium may still be embedded in the euro, upcoming events in the US will be crucial in determining whether the EUR/USD can approach the 1.1000 level.

In conclusion, the French parliamentary elections have ushered in a period of negotiation and uncertainty, yet the risk of significant market volatility has lessened. Historical precedents of prolonged coalition talks, the stability of the current government, and the relative strength of Macron's Ensemble contribute to this stability. The EUR/USD exchange rate reflects these dynamics, with the potential for further strengthening contingent on upcoming economic developments in the US.

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