French Election Risk Reawakens as Bonds Drop, Volatility Jumps

French election risk is slowly creeping back into markets.

The nation’s bonds fell on Monday, widening the yield spread over Germany to the highest since February. Meanwhile the CAC 40 index of stocks dropped and a gauge of two-week euro volatility that now covers the first round of voting, surged.

Jitters over the outcome of the France’s presidential election have increased after the far-left politician Jean-Luc Melenchon jumped in the latest polls, making the election a four-way contest, and boosting the small possibility of a second-round contest between the Communist-backed candidate and the anti-euro Marine Le Pen.

“The revival of new election risk in the form of Melenchon isn’t helping to support French spreads,” said Kim Liu, strategist at ABN Amro Group NV in Amsterdam. “It’s actually weakening the momentum.”

The yield difference between French and German 10-year bonds widened three basis points to 70, the highest since February, based on closing prices, while a measure of two-week euro volatility against the dollar spiked to 10.60 percent, the highest in more-than three months. The CAC 40 Index fell 0.5 percent, underperforming a wider European gauge, with Societe Generale SA, BNP Paribas SA and Natixis SA among the top 10 fallers among the region’s banks.

Melenchon is not a candidate who will be viewed positively by the market given the left-wing nature of his economic policies, according to strategists at Rabobank. The bank still recommends selling France’s bonds versus Germany heading into the first-round of the vote. Meanwhile James Athey, a fixed income portfolio manager at Aberdeen Asset Management in London, is running a short position on the euro. A victory for Melenchon wouldn’t be a market-friendly outcome, the fund manager said in an interview last week.

Liquidity heading into the Easter holiday in Europe is expected to exacerbate the moves in rates and currency markets, according to a trader in Europe who spoke on condition of anonymity as the person is not authorized to speak publicly. Volumes on the CAC 40 were 23 percent lower than their 30-day average on Monday.