LONDON Investors who worry that the French election could see the far-right Marine Le Pen reach the second round are bracing for another risk - that the far-left Jean-Luc Melenchon could make it too, perhaps even against her.
With just 12 days to go until the first round of voting in the presidential election, polls are tightening. For weeks investors have been betting that the run-off would be between Le Pen and the centrist Emmanuel Macron, with Macron beating the far-right candidate comfortably in the second round.
But investors are rethinking that assumption. A poll from Ifop on Tuesday put Melenchon in third place, ahead of the conservative Francois Fillon and just four points behind Macron, and confirmed that almost one-third of voters are still undecided.
The late surge for Melenchon, who wants to slap a 100 percent tax on the rich, leave NATO and renegotiate France's position in the European Union, is spooking markets and prompted a warning on Tuesday by the head of the business lobby group Medef Pierre Gattaz.
The cost of hedging against volatility in the euro over the next month against both the dollar and yen jumped to the highest levels since the results of Britain's vote to leave the EU last June EUR1MO= EURJPY1MO=.
One-month risk reversals - a gauge of demand for options on a currency rising or falling - fell to -4.175 vol, showing the strongest bias for euro weakness since November 2011. EUR1MRR=FN
"The risks going into the first round of the election have been underpriced by the market, especially with that new dynamic introduced by Melenchon’s performance in the polls," said Credit Agricole's head of currency strategy in London, Valentin Marinov.
"The risk of having a far-left versus far-right second round was on no one’s radar screen until now, and that latest development is highlighting that such an outcome should not be ruled out."
The euro hit a four-month low against the safe-haven yen EURJPY= in a broad flight to safety as investors sought refuge from the risks surrounding the French election as well as growing tensions between the United States and Russia.
FRENCH BOND DUMP
"French political risk is back!" read an ABN Amro research note on Monday afternoon.
"The gap between (Macron and Le Pen) and Mr Melenchon is about 5 percent of the votes, which seems small considering that approximately 30 percent of voters are still undecided."
In debt markets, the gap between French 10-year government bond yields and their German equivalents stretched to its widest in six weeks. FR10YT=TWEB DE10YT=TWEB [GVD/EUR]
Japanese bank Nomura said on Tuesday it would enter an "outright short" position to bet against French government bonds if Melenchon were to face Le Pen in the run-off on May 7.
Japanese investors, who are large holders of French debt and are therefore seen as a proxy for foreign investors, dumped a record amount of French bonds in February, data from Japan's Ministry of Finance showed on Monday.
(Additional reporting by Helen Reid; Editing by Tom Heneghan)