* Anticipation of Hollande victory weighing on bond, stocks
* Forex traders lay down bearish bets eyeing fiscal slippage
* Equity market to see winners and losers, volatility rise
By William James and Simon Jessop
LONDON, April 19 (Reuters) - Financial markets are unlikely to greet the expected election of a Socialist French president with enthusiasm, except perhaps those placing early bets that bond yields will rise, the euro will fall and equities will be more volatile.
With the first round of voting on Sunday, Socialist candidate Francois Hollande is poll favourite to win on the second round on May 6, raising concerns that his grip on government finances will be lighter, and a euro zone agreement on fiscal discipline might be unpicked, though his campaign team has backpedalled on earlier pledges to renegotiate it.
Not that many take a much better view of the incumbent conservative Nicholas Sarkozy, whose fiscal plans, like Hollande‘s, rest on growth projections that economists polled by Reuters consider over optimistic.
Much of the difference between their deficit reduction programmes is a matter of timing; Hollande plans to balance the books by 2017, while Sarkozy is targeting 2016.
Economists in the Reuters poll don’t expect either of them to get there on what they’ve promised so far.
“If we don’t see a reversal of campaign statements after the elections, then we could possibly see a market attack,” said Marie Diron, economist at Oxford Economics.
“More and more clients are calling us to get products linked to the election,” a Paris-based equity derivatives trader said.
“Everyone sees the risk on the downside for French assets, because if Sarkozy gets re-elected, France’s deficit problems won’t be resolved overnight, while with Hollande, the fact that the deficit reduction doesn’t seem to be his priority is nothing to reassure investors.”
Confidence in the euro zone is already running low, with Spain’s shaky finances threatening to drag the region back into crisis and prompting investors to retreat from assets that could suffer by association.
Sarkozy warned last week that a Hollande victory would set off a crisis of confidence, a view his challenger derided as encouraging speculation for personal gain to the detriment of France. Central bank governor Christian Noyer said he saw no reason for markets to attack France, as long as “the clarity, persistence, and priority of the (debt reduction) path is affirmed”.
Many in the market have got their reaction in ahead of the result; in a month-long move away from riskier assets, French bonds have fared worse than other core euro zone countries, and the benchmark cost of insuring French debt against a default has broken above 200 basis points for the first time since January.
On the stock markets, France’s CAC 40 index has underperformed the German and UK equivalents, while expectations of wilder swings for the French index have risen by 50 percent in the last month.
The volume of French shares out on loan, a proxy for activity by short-sellers, who aim to profit from falling prices, has also risen markedly.
Data Explorers said short interest had risen 4 percent over the last month to 3.25 percent of the CAC, with advertising group Publicis the most shorted stock, with a 40 percent jump in short interest in the run-up to its results on Thursday.
Some currency traders, meanwhile, have been placing bets designed to profit from a fall in the euro on May 7, the day after the final round of the presidential election, highlighting the wider impact a Hollande victory might have.
The trade involves investors buying euro/U.S. dollar options that give them the right to sell the euro at $1.25.
With the single currency last trading around $1.31, the value of the option would increase on any fall towards $1.25 over the next 18 days, allowing it to be sold on at a profit.
Traders have already cited significant selling of French bonds that coincides with the falling away of Sarkozy’s challenge to Hollande’s healthy opinion poll lead.
“We wonder if French fund managers have decided that the Sarkozy bounce isn’t going to happen, and they’re going to start taking some preventative action, because the markets might try and give Hollande a rough ride very early on,” said one London-based bond trader.
Royal Bank of Scotland bond strategists recommend a trade designed to profit from a rise in French 10-year bond yields relative to Germany, targeting a gap of 160 basis points between the two. The spread last stood at 140 bps.
As investors look to mitigate the risk that a Socialist victory undermines bond market investor confidence, the price of credit default swap insurance contracts - a popular risk-hedging tool - could rise as high as 220 bps, according to Bank of America Merrill Lynch.
With Hollande looking to increase spending in some areas to help boost growth, the outlook for equity markets is potentially more mixed, prompting investors to single out companies and sectors likely to be affected by policy shifts.
UBS see potential stock winners in the housing and construction sector, for example electrical fitting maker Legrand, while losers could include Thales, Europe’s largest defence firm.
Citi’s political analysts pinpoint banks, insurers and the nuclear industry as the sectors most likely to be hit.
To mitigate the election impact, Credit Suisse advised clients to buy firms with more than 30 percent of sales outside continental Europe, citing concerns about the French economy, including a poor record on deregulation, an expected rise in corporate tax and high labour costs.
Holding on to the view that a new president will produce both winners and losers, an alternative way to profit from the expected turbulence is to use equity derivatives to bet that the spread of returns on stocks will widen using a call option structure, BNP Paribas said.
“The CAC itself will have some stocks that will perform well and others that won‘t, so net-net they could cancel each other out ... So playing an absolute dispersion trade could be more interesting than simply having a directional view on the index,” said European head of equity and derivatives strategy, Kokou Agbo-Bloua.