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Le Pen nerves hit French debt but euro impact unclear

France's National Front leader Marine Le Pen gives a speech during a European far-right leaders meeting to discuss about the European Union, in Koblenz, Germany, January 21, 2017. REUTERS/Wolfgang Rattay

By John Geddie and Jemima Kelly LONDON (Reuters) - Nerves around France's presidential election are starting to play out in debt markets, although the euro seems as yet unruffled by a vote which could pose the biggest existential threat to the single currency bloc since the 2011/2012 debt crisis. Investors are concerned the wave of populism behind Britain's vote to leave the European Union and the election of Donald Trump in the United States could sweep French far-right leader Marine Le Pen into power in 2017. Le Pen wants France out of the euro and while it is unclear if she could even hold, let alone win, a referendum, few think the bloc could survive without its second-biggest power. That threat has pushed the gap - or spread - between French and German government borrowing costs to its widest in nearly three years and there are signs that some of France's most loyal investors may be deserting them. But options market pricing on Tuesday showed few immediate signs of concern among currency investors about the impact of a possible Le Pen victory on the euro. "What happens in the European sovereign spread space is really where you start to see your earliest warning signs of what's potentially going on," said Bank of New York Mellon's head of currency strategy, Simon Derrick, in London. "But the French election is significantly less of a risk (to the euro) than the Brexit referendum or the U.S. election, because there were direct outcomes. Here there's the complexity of French politics." While polls show Le Pen is likely to make the final two-person runoff in May, with some showing her mustering the most votes in April's first round, she is expected to ultimately lose to a more moderate candidate - probably the centre-right's Francois Fillon or independent centrist Emmanuel Macron. Even if she springs a surprise, her "Frexit" ambitions will require constitutional change which experts say will be difficult, especially as her National Front party only has a handful of federal lawmakers. That may explain why, in the context of previous euro zone crises, the recent sell-off in French bonds remains modest. INVESTORS LEAVING In late 2011, when investors fretted about French banks' exposure to Greek debt as Athens headed for another bailout, France had to pay 2 percentage points more to borrow 10-year money than Germany. It now pays around 0.5 percentage points more. The crisis pushed Spain and Italy, the bloc's third- and fourth-largest economies, towards bailouts in arguably the biggest test the currency union has faced. A rise in bets against French debt, as suggested by futures markets, hint there may be more pain to come before the election. The open interest on French futures has almost doubled since Trump's win in November, and as that has been coupled with a fall in the value of the contract, analysts say it suggests investors are taking "short" positions. http://reut.rs/2kmRttI Also in November, Japanese investors, historically among the biggest foreign buyers of French debt, sold France's bonds on a scale not seen since mid-2015. http://reut.rs/2kmPtSl "(The Japanese) will probably go to Australia or the U.S. for the time being, and we are in the same boat," said Ryan Myerberg, portfolio manager at Janus Capital. "We will be very happy to stay like that until we get through the second round of the French election." "PAIN TRADE" Currency traders face not only the uncertainty of the election outcome and the possible risks carried by a Le Pen victory, but also the risk that the euro could rally on such an outcome. That happened during the 2015 Greek crisis, when it was used as a safe haven. "A Le Pen victory would probably be an exogenous shock for the world, so if we were heading into a period where you were expecting the U.S. to raise interest rates at the mid-year point, you would wipe out those moves and perhaps the euro would just go up, perversely," said Richard Benson, co-head of portfolio investments at Millennium Global currency fund. Though Benson said the market consensus was for the euro to fall 5 to 10 percent on a Le Pen victory, that would be contingent on what was going on in the rest of the world. Whereas the Brexit vote had a direct impact on the economy and currency because of Britain's reliance on foreign investment to fund its huge current account deficit, the fundamental impact on the euro zone, which has a large current account surplus, would be less straightforward. Even in bond markets, some say further market jolts could be a reason to buy back in. "Investors, especially in the UK, would like to make money by short-selling French bonds but it is a pain trade because they are very liquid and always in demand," Nicolas Forest, global head of fixed income at Candriam Investors Group said. "Everyone is betting that there could be a surprise after Trump and Brexit. But that could prove to be a buying opportunity." (Editing by Janet Lawrence)