French stocks and bonds fell on Tuesday as markets started to acknowledge the risk of far-right candidate Marine Le Pen winning this month's presidential elections against incumbent Emmanuel Macron.
France's benchmark CAC-40 equity index was down 1.3% by 1215 GMT, underperforming the pan-European STOXX 600 index which was flat.
French government borrowing costs also surged, with yields on 10-year debt up 10 basis points.
The spread between the yield of 10-year French and German government bonds -- essentially the premium demanded by investors to hold French debt -- rose to 54 basis points, levels unseen since the COVID-19 market crash of 2020.
Le Pen, whose presidential campaign has gained momentum in recent days, on Monday captured 48.5% of voter intentions in an opinion poll of a likely runoff against Macron, the highest score she has ever notched.
The Harris Interactive poll for business magazine Challenges said a Macron victory - which pollsters had considered almost a foregone conclusion - was now within the margin of error.
"Markets woke up on Le Pen," said Jerome Legras, head of research at Axiom Alternative Investments.
French banks Societe Generale, BNP Paribas and Credit Agricole took the biggest hits with losses of 4-6%, far more than the 1.3% fall on a broader European banking index.
One trader said the selloff was particularly notable in stocks seen vulnerable to a Le Pen election.
"Look at Vinci and Eiffage, their underperformance is a casualty of Le Pen risk", the trader said, pointing to the far-right leader's plans to nationalise French highway operators.
Shares in the two infrastructure groups fell around 5% on the day.
The turmoil rekindles memories of the 2017 election when fears of a far-left or far-right win sent French government borrowing costs soaring and pushed stocks sharply lower.
Many investors see Le Pen's platform, which aims to keep the legal retirement age at 62 years, as generous in terms of public spending. She is also viewed as less business-friendly than Macron.
"Le Pen would likely be seen by markets as less reliable on public spending and economic competitiveness, and an unenthusiastic motor and/or unreliable partner for Germany and NATO at a crucial moment for Europe and the West," NatWest economist Giovanni Zanni told clients last week.
FRENCH DEBT
Zanni reckons a surprise win for Le Pen could deliver a 50 basis points hit to French 10-year spreads over Germany -- essentially the premium demanded by investors to hold French debt. That would take the spread to a similar level as Spain which has a lower credit rating.
In the run up to the 2017 election, spreads had blown out to nearly 80 bps.
Francois Raynaud, multi-asset fund manager at Edmond de Rothschild Asset Management, said selling French debt -- known as OATs - versus the German Bund through 10-year futures was a good hedge against a surprise election result.
"By default, it seems judicious to us to take up protection by being underweight in terms of French weightings versus other indexes, or via the OAT futures," Raynaud told Reuters on Monday, before the latest sell-off.
Many investors remain unfazed -- Grace Peters, head of EMEA investment strategy at JP Morgan Private Bank, still favours French stocks, especially luxury and energy which are less vulnerable to the domestic economy.
"A Le Pen victory is the wild card out there which could be disruptive. But the base case is still for Mr Macron," Peters said.
Others are scanning markets for risks.
The euro fell a quarter percent against the safe-haven Swiss franc on Tuesday to a one-month low but Adam Cole, a strategist at RBC Capital Markets, sees the euro's risk premium as likely to rise in coming weeks.
"Might financial markets also be showing signs of complacency ahead of the polls? We think that is a significant risk," he said.
(Reporting by Julien Ponthus and Samuel Indykin London, Sudip Kar-Gupta in Paris and Danilo Masoni in Milan; Editing by Sujata Rao and Ed Osmond)
