08:20 AM EDT, 06/28/2024 (MT Newswires) -- After initially dropping sharply following the announcement of snap parliamentary elections in France, EUR/USD has stabilized around 1.0700, but next week could see renewed volatility depending on the result of the election's first round on Sunday, said Mitsubishi UFG.

The bank initially estimated around a 1.0% risk premium was possibly priced into the euro and based on short-term price action against variables like spreads, this remains a reasonable estimate.

The first round of the election on Sunday will give investors a sense of the true support for the various parties compared with the polls MUFG has used to gauge support so far.

For a candidate to win one of the 577 constituencies he or she must win an outright majority with support of at least 25% of all eligible voters. A candidate that wins 52% of the vote but because of a low turnout only wins 24% of the total eligible to vote would have to run in the second round. As a consequence, first-round wins are rare -- there were just five in 2022.

In past elections, far-right RN has had difficulty getting wins in the second round because centrist parties aligned in the second round to defeat the RN. This time that is likely to be more difficult with a large number of constituencies in the second round offering a choice between RN and the far-left alliance (New Popular Front, or NPF).

So on Monday, the bank will know exactly how squeezed out the centrist candidates were in round one and the greater that squeeze is the greater the chance of an outright majority in round two for RN or perhaps NPF.

Based on the polling, MUFG believes there are perhaps four plausible scenarios: 1) RN wins the most seats but falls short of an outright majority (45%); 2) RN wins an outright majority (25%); 3) NPF wins the largest number of seats but falls short of an outright majority (20%); 4) there is no clear winner and there is complete paralysis with no obvious root to a working government (10%).

These are initial scenarios evident in the immediate aftermath of the second round election on July 7, wrote the bank in a note to clients. In other words, scenario 4 could eventually shift and a government is formed but initially it isn't obvious.

MUFG has also raised the probability of an RN outright majority based on the interviews from Marine Le Pen and Jordan Bardella that certainly point to a willingness of the RN to be pragmatic and possibly park some of their initial more contentious policies for a period of time.

The tone from RN suggests the flippant spending and large fiscal deficits touted in 2022 are unlikely, which would potentially contain the market fallout in scenario 2.

Based on RN communications, it seems the worst scenario would be scenario 3) and certainly from a bond market perspective this would fuel the widest OAT/Bund spread move.

Scenario 4 isn't particularly positive either but the market move might be contained in the hope of an eventual path to a governing coalition can be found.

For next week, the larger the number of consistencies that have resulted in the failure of centrist candidates making the final ballot, the greater the negative reaction might be, according to MUFG. A surprise outperformance for NPF would also likely fuel greater OAT and EUR selling.

If RN and NPF were to do worse than expected at the expense of President Emmanuel Macron's Ensemble or Les Republicains, investors will likely see some spread narrowing on Monday and some modest EUR gains. With the EUR risk premium relatively modest strong RN & NPF performances will likely see EUR/USD close to the 1.0500-level, added the bank.