How to hedge against a ‘Frexit’

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The spectre of Marine Le Pen is looming over the bond markets.

Three months ahead of the country’s presidential elections, French bond yields are climbing, with the perceived riskiness of its debt against Germany’s rising to a four-year high this week.

Much of the jitters have been sparked by Ms Le Pen’s promise to unilaterally take France out of the single currency within six months, sparking concerns over possibly one of the biggest sovereign defaults in the world should she make good on a promise to redenominate €1.7tn of France’s outstanding debt (more on that here).

So how to hedge against a ‘Frexit’?

Should France adopt a new franc, analysts at Bank of America Merrill expect the currency would depreciate significantly in value against the euro on account of the unprecedented uncertainty unleashed on the continent.

It would also raise the prospect of the newly independent French treasury and Banque de France engaging in a blitz of “debt monetisation” – where the central bank would directly finance Ms Le Pen’s ambitious spending plans to help revive the country’s moribund industrial heartlands.

This would likely culminate in a major inflation spike for the French economy from its currently “lowflationary” levels.

BAML strategists recommend investors hedge themselves by betting on rising French versus eurozone inflation. They advise buying the “spread” – or the difference – between market expectations of future inflation. These can be traded through the “5 year 5 year” forward inflation swap rate (which measures the difference in the yield on nominal and inflation linked bonds).

A Frexit would also throw the future of the eurozone’s “weaker” economies into sharp relief. There are already signs of a creeping “redenomination risk” – or the threat of a potential reversion back former national currencies – returning to the eurozone sovereign bond markets in recent weeks.

The premium investors are demanding to hold Italian versus Spanish debt has has swelled to a four-year high, along with the yield spread between Portugal and “ultra-safe” Germany. Bunds are likely to be the biggest beneficiary of the eurozone-break up hedge (more from the FT’s Miles Johnson here).

“Should concerns grow of a ‘domino effect’ with other eurozone departures perceived as more likely, we would see this as most adverse for the periphery and the market might come to regard the currency risk as biased towards a hardening of the euro, with ‘core’ members becoming dominant”, notes Mark Capleton at BAML.

And with the potential viability of the single currency project at risk, Antje Praefcke at Commerzbank expects the European currency haven of choice – the Swiss franc – to come under fresh upward pressure:

It is quite difficult to find the currency that will emerge as the winner from these complex conditions – either short or long term. However, one ultimate safe haven is once again emerging: the Swiss franc

It may be an expensive task to resist the appreciation of the ultimate safe haven in political markets dominated by uncertainty and imponderability.

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