EUR/USD: Fading French political turmoil with the White Knight on standby

• French government faces collapse over a €60bn austerity plan
• Despite heightened media coverage, French turmoil isn’t moving EUR/USD
• EUR/USD is more influenced by relative US-European growth and inflation expectations
• ECB likely to intervene if things get worse, limiting the impact of French politics

Overview

Perhaps it’s because we’re in a shortened holiday week in the United States, providing financial media with only a fraction of usual content, but the latest French budget drama sure is getting a lot of coverage, implying it’s something important to monitor. That may be so if you’re an OATs or basis trader, or like to punt the CAC, but if you’re focused on the euro, forget about it. It’s another case of ample noise and little signal.

This note will explain why French headlines should be faded for the time being, with the growth and inflation trajectory of the United States and Europe far more relevant to the EUR/USD. 

French political chaos 101

For those not keeping tabs, and who could blame you, France’s minority government under PM Michel Barnier is teetering on collapse. His €60 billion austerity plan, aimed at reining in ballooning deficits, has infuriated opposition parties, alienated voters, and rattled markets. Marine Le Pen, leader of the National Front, is threatening to topple the government, adding to what comes across as a perpetual state of political unrest to the outsider.

Years of unfunded tax cuts, combined with pandemic and energy-crisis spending, have left the French budget position in disarray with 6.1% deficit projected this year, more than double the acceptable EU level. The infighting and uncertainty have seen yield spreads between French and German benchmark 10-year bonds balloon to levels not seen since 2012, the peak of the Euro area debt crisis for those who weren’t around back then. I’m still trying to forget!

Not there to close spreads, until it does

So, sounds serious, right?

Well, it would be if the ECB didn’t have a track record for riding in like a White Knight to save the day whenever the euro experiment comes under threat, and this time will be no exception. Christine Lagarde might have stipulated years ago that the ECB are not there to close sovereign bond spreads, but no one believes her, especially when we’re talking about her own country. It's implied across markets that the White Knight will be there when times are the darkest.

Fading French politics, watching economic developments

You can see that chart below tracking correlation coefficient scores between EUR/USD with outright and relative bond yields across Europe and either side of the Atlantic over the past month.

Source: TradingView

The relationship between French and German benchmark yield spreads has been mildly negative, suggesting there may be some small influence. But then you look at the correlation with French 10-year bond yields and its mildly positive, meaning there has been a tendency for both to move in the same direction – that simply doesn’t fit with the dramatic headlines.

The tightest relationship has been with US and German 10-year year spreads, with an extremely strong negative correlation of -0.94. When you see a similarly strong inverse relationship with Fed rate cut pricing over the next year, it reinforces that EUR/USD moves are not being driven by French political turmoil but relative growth and inflation expectations between the United States and Europe.

That puts today’s euro area November inflation and next Friday’s US nonfarm payrolls report front-and-centre of those events that could meaningfully shift EUR/USD over the next week.

EUR/USD consolidates following corrective bounce

Source: Trading View

The corrective bounce in EUR/USD from the lows set last Friday has stalled ahead of resistance at 1.0600, making that a reference point for traders near-term. Signals from momentum indicators like RSI (14) and MACD don’t make a compelling case for an extension of the move, with the former already rolling over. As such, interactions with 1.0600 may provide a guide on how to position heading into December.

If the price cannot break and close above 1.0600, shorts could be established beneath the level with a stop above for protection. The pair has done some work either side of 1.0530 in recent days, making that a focal point, although the lack of volume going through makes me dubious as to whether it will hold up if put under pressure. Aside from 1.0500 and 1.0400, the obvious target would be the year-to-date low of 1.0333.

Alternatively, if we see the price break and close above 1.0600, you could swing the setup around, allowing for longs to be established above with a stop beneath for protection. 1.0666 may offer some resistance but there’s not a lot to speak of until above 1.08000.

Given the tight inverse correlation between EUR/USD and US-German 10-year bond spreads, rather than French politics, watching price signals from US 10-year Treasury note futures may provide directional clues not only for spreads but EUR/USD movements. I wrote about that in a separate note earlier this week.

-- Written by David Scutt

Follow David on Twitter @scutty