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* French stocks set for best one-day gain in a month
* Euro hits 3-week high, French/German yield gap at 2-week low
* Analysts cite covering of short positions before French vote
* First round of voting in French presidential race on Sunday
By Dhara Ranasinghe and Helen Reid
LONDON, April 20 (Reuters) - With less than 36 hours of trading to go before the first round of the French presidential election, a likely squaring of positions on Thursday saw the euro rally, French banking stocks rise and government bond spreads narrow.
The run-up to the French vote, which polls suggest will pit far-right candidate Marine Le Pen against the centrist Emmanuel Macron in a runoff in May, has battered French bonds and seen market measures of implied currency volatility surge.
But analysts said the rally in the euro and French assets on Thursday suggested some investors were closing out of their short positions before Sunday’s first round-vote, taking heart perhaps from latest polls showing Macron easily beating Le Pen in the second round two weeks later.
“There’s bound to have been an element in the market of people just playing the run-in to the election as a trade, and were positioned for the risk premium to have blown out a bit more by the time we’d come to the second-last trading day before the first round,” said Derek Halpenny, European head of global markets research at MUFG in London.
“The fact that hasn’t materialized by now is encouraging those risk-takers who never were going to run the risk through the election anyway to essentially close out their positions.”
The euro rose to a three-week high at around $1.0778 and was on track for its best week this year.
A rally in banking stocks lifted France’s CAC 40 up as much as 1 percent, easily outpacing broader European markets. French stocks were set for their biggest one-day gain in a month.
BNP Paribas and Societe Generale shares both rose more than 2 percent and Credit Agricole rose just over 1 percent.
Columbia Threadneedle Investments said on Thursday it had increased its exposure to European equities, since political risk is increasingly discounted, valuations are lower and earnings momentum is positive in Europe.
Macron has held on to his position as the favourite to win eventually, the latest polls show, although they also indicate that the outcome of the first round of voting on Sunday is too close to call.
The premium investors demand for holding French government bonds over top-rated German peers, meanwhile, has narrowed to its tightest level in almost two weeks at 64 basis points .
French bonds have borne the brunt of election jitters this year, with the French/German yield gap widening out to as much as 84 bps in February.
Strong support for the anti-euro Le Pen and the far-left’s Jean-Luc Melenchon has alarmed investors.
But with jitters ebbing slightly as polls remain consistent, the yield on safe-haven German Bunds rose to a 1 1/2-week high of 0.24 percent on Thursday. Markets also easily digested a new supply of French three and five-year government bonds, the last French debt sale ahead of Sunday’s election.
“It seems that when we have a major event, people think the base-case scenario will materialise,” said Jan von Gerich, chief strategist at Nordea Markets. “We saw that in the market reaction just before the Brexit referendum and we’re seeing it again now with France.”
But Britain’s vote on EU membership last June and the U.S. presidential election in November did take markets by surprise. That should be a reason for caution, some analysts said.
“Market behaviour is starting to look worryingly similar to the run up of the Brexit and Trump vote, where investors started to overweight marginal shifts/info in polls, creating a self-reinforcing belief that things are OK,” Deutsche Bank analyst George Saravelos said in a note. (Additional reporting by Jemima Kelly and Patrick Graham, editing by Larry King)