French election Correlations start to rise as investors get nervous

At City Index we have been taking a look at correlations this week, specifically how the S&P 500 has experienced a break down in its relationship with other risky assets. One correlation that is, unsurprisingly, holding up, is the relationship between French 10-year bond yields and European stock indices.

We would expect French bond yields and European stocks to be highly correlated as we lead up to the French election, the first round of voting is on 23^rd April. With just over a week to go, the race is getting more interesting as the Far-Left candidate Melenchon is seeing his support surge, while front-runner Macron has seen his chances of winning the keys to the Elysee Palace dip from last week’s high. The risk is that the far left and the far right make it into the second round run-off. Although this outcome still has a slim probability, the market is showing signs of nervousness about a shock result from the French election.

The correlation matrix below shows the short –term correlations between the Cac 40, French 10-year bond yield, EURUSD, Dax and the Eurostoxx index.

Figure 1:

Source: City Index and Bloomberg

Here are a few conclusions:

• The strongest correlation is between the EURUSD and the Cac 40. The Cac and EUR/USD had an insignificant correlation of -47% at the start of this month. However, this correlation has turned on its head and is now 99%, which suggests that the Cac and the EUR are mostly moving in lockstep since the polls have detected a surge in support for Melenchon.
• At the beginning of April the Cac 40 and French 10 –year bond yield, which we are using as a proxy for French election risk, had a negative correlation of -64%, this has risen to -67% this week.
• The Dax and the Eurostoxx index have also experienced increased levels of sensitivity to French election risks this week. At the beginning of April the Dax and Eurostoxx had correlations of -59% and -64% to the French 10-year bond yield, respectively. Since the end of last week, sensitivity has increased to -75% for the Dax and -95% for the Eurostoxx index. This means that when the French 10-year bond rises, the Dax and Eurostoxx tend to fall.
• If this repeats itself, then we would expect European stock indices to remain sensitive to French election risks until at least the first round of voting is complete.
• If we get more signs that Le Pen and Melenchon are gaining in the polls ahead of the vote on 23^rd April, then we could see an immediate rise in French bond yields, a sell-off in the euro and further weakness in French and European stock indices.