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Europe's election season is about to kick off, and investors are feeling nervous. The Netherlands goes to the polls on 15 March, with the Freedom Party led by Geert Wilders likely to make big gains on a platform of leaving the EU and the euro. A month later, France will vote in its two-round presidential election: far-right leader Marine Le Pen looks certain to be in the second round. Over in Germany, Angela Merkel is slipping in the polls. Italy's chaotic government may soon face another election too.
As a result of all this, the yield on French ten-year bonds has almost doubled in the last few weeks, and the spread against the German bund, a key measure of political risk, has widened to its highest level in three years. As analysis by JP Morgan points out, the markets are betting against France and Italy, mainly via the bond market. But they are not betting against Europe as a whole the currency had barely moved against the dollar in the last three months, and the German bond market is as solid as ever.
That is surely a mistake. If Wilders is elected in the Netherlands, or even more dramatically Le Pen in France, then it will be the trigger for a much wider eurozone crisis. So what should the markets be shorting? First, and most obviously, the euro. The populist parties don't really do detailed programmes for government, but they have all made it clear they are planning to ditch the single currency. Wilders has a vague plan for a new Dutch gilder to shadow the euro, but it's hard to see that surviving for more than five minutes.
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Le Pen has been a little more explicit, with a bizarre plan for restoring national currencies within Europe, which would then be "managed" by national central banks she seems to have forgotten that was precisely the system that crashed back in 1992. In reality, if the Dutch leave, and even more so if the French get out, the euro will effectively be finished. The only right response is to short the currency itself.
Next, the banking system. It is hard to see how the French banks, still some of the biggest in the world, could survive a Le Pen government. She plans to re-base all the outstanding French government debt into new francs, but that currency would sink like a stone on the market. The banks would effectively be bust, and would almost certainly be nationalised by what would be the most protectionist, interventionist government Europe had seen since the 1930s. The ripples of that would spread right across the continent it is not just the French banks that hold a lot of that country's debt on their books. The entire sector would be vaporised.
Finally, Germany. It might be seen as the strongman of the European economy, and in some respects it is. But if populist governments start pulling out of the euro, it's Germany that will have to pay the bill. German banks are already on the hook for debts across the eurozone, and those would eventually have to be settled by the state. he European Central Bank has built up an estimated €96bn of liabilities across the eurozone.
If countries start leaving, it's hard to see who else would end up with the bill. And that's before you take into account the loss of its exports to a protectionist France. German bunds may be priced as if they're a solid safe haven, with yields close to zero, and sometimes below, but that wouldn't survive long in a real crisis.
If any of the populist parties take power in Europe, the ramifications will be far wider than investors are betting on. It will be the eurozone itself that will be under threat, along with its banking system and the German economy. It will be plunged into crisis. If you want to bet on turmoil ahead, then those are the trades to make the rest is a sideshow.
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Matthew Lynn is a columnist for Bloomberg, and writes weekly commentary syndicated in papers such as the Daily Telegraph, Die Welt, the Sydney Morning Herald, the South China Morning Post and the Miami Herald. He is also an associate editor of Spectator Business, and a regular contributor to The Spectator. Before that, he worked for the business section of the Sunday Times for ten years.
He has written books on finance and financial topics, including Bust: Greece, The Euro and The Sovereign Debt Crisis and The Long Depression: The Slump of 2008 to 2031. Matthew is also the author of the Death Force series of military thrillers and the founder of Lume Books, an independent publisher.
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