The euro, French government bonds and European stocks closed sharply higher Monday after centrist candidate Emmanuel Macron won the most votes in the first round of France's presidential election, a reaction that may herald a broader realignment of European markets recently plagued by concerns over political risk.
Mr. Macron is the overwhelming favorite to win May 7's runoff against second-place finisher Marine Le Pen, whose anti-euro stance had concerned investors.
As European trading hours ended, the euro was up around 1.2% at $1.085, after touching five-month highs of $1.0935 overnight. The differential between yields on French government debt and German government bonds, seen as a haven investment, narrowed from 0.64 of a percentage point Friday to as little as 0.42 of a percentage point Monday, the narrowest spread this year. The French CAC-40 stock market index surged 4.1%, driving the broader Stoxx Europe 600 up 2.1%.
Some investors believe this relief rally will continue, with an increased appetite for the euro and European stocks as electoral worries fade and the continent's improving economy comes further into focus. The increased appetite for riskier investments such as shares may hit bonds, which have benefited from haven buying and a massive European Central Bank bond-buying program that some analysts believe will be scaled back this year.
"The balance of discourse was just so skewed against the euro," said Geoffrey Yu, head of U.K. investment office at UBS Wealth Management. "As we move away from the politics, we think the euro is going higher. It's still quite cheap at these levels relative to long-term averages."
Political risks, particularly around the French election, have been investors' biggest concern for European markets this year. That's especially after the surprise results of last year's U.K. Brexit vote and the U.S. presidential election and after Italians rejected attempts at political overhaul.
Investors put money into safer investments, including bonds and German government debt, and often avoided Europe's weaker southern economies.
German bonds sold off sharply Monday. Yields on 10-year bunds rose to 0.35% from around 0.245% on Friday. Yields move inversely to prices. Gold, another haven that has benefited from concern over political risk, was down 1.52% in the wake of the French vote.
French government bonds, meanwhile, rallied alongside those of Italy, Spain and Portugal, the three European markets that typically sell off when investors are concerned over the risks of a breakup of the eurozone.
Investors had been concerned by the prospect of a strong showing by Ms. Le Pen, the far-right leader of the National Front, or by the far-left candidate Jean-Luc Mélenchon. Ms. Le Pen wants to pull France out of the currency union, and Mr. Mélenchon had advocated scrapping some of its core fiscal rules, positions that would spell trouble for the euro and French government bonds.
As recently as last week, some analysts were forecasting the euro would fall to parity with the dollar, a prediction that has been popular for more than two years but has yet to happen. After the French result, Deutsche Bank said it is in the process of updating its forecasts, which previously had been among the most bearish and predicted the euro would fall to $0.95 by the end of 2017.
Bank of America Merrill Lynch's prediction that the common currency will hit $1.05 by the end of 2017 is now more likely to be raised than cut, said Athanasios Vamvakidis, head of G-10 foreign exchange strategy at the bank.
One-month risk reversals, a measure of how much investors are paying for protection against a sudden crash in the euro's value, reached their most expensive levels on record last week, touching minus 4.4%. The measure returned to minus 1.45% on Monday, with more negative numbers meaning investors are shelling out more to hedge against a slump.
To be sure, political and other risks remain in Europe. Investors see a gamut of problems for Italy, the eurozone's third-largest economy, with weak growth, banks with bad loans and sky-high public debt. They also wonder what happens if the ECB begins to scale back its massive quantitative-easing program, which has supported the bonds of weaker economies and boosted shares.
"European government bond yields will likely come under pressure in the months ahead," Anthony Doyle, fixed interest investment director at M&G Investments, said in an email. "As will European investment grade corporate bonds that have benefited from the ECB's bond buying programme."
Ms. Le Pen may also still win. "It is probably too early for markets to see a big relief rally just yet," said Anna Stupnytska, global economist at Fidelity International.
But most analysts and polls expect Mr. Macron to win comfortable May 7, as French voters rally around a candidate who isn't Ms. Le Pen.
"The result showed what the polls had suggested, which suggests Macron is really quite likely to win the second round," said Paul Meggyesi, foreign exchange strategist at J.P. Morgan.
"Given how mispriced European assets are, there's scope for significant moves. Fixed income is expensive in Europe, and the euro is still cheap, " he said.
Investors' nerves already had been soothed somewhat by a mid-March election in the Netherlands, when Prime Minister Mark Rutte beat anti-euro populist candidate Geert Wilders.
Inflows into Europe's equity markets have been picking up, according to data provider EPFR Global. Investors have moved about $5 billion into European equities since the beginning of the year, with a rise in inflows in the past four weeks.
"International investors have been burned a bit in the past few years, so they've been reticent to get involved," said Kevin O'Nolan, portfolio manager at Fidelity International. "But the perception that the center, the establishment, is reasserting itself is good for investors."
If Mr. Macron becomes president, most analysts expect investors to keep embracing risk in Europe. Economic data has outperformed expectations broadly this year. Business surveys in France are hinting at the fastest expansion for the country in nearly six years.
This is likely to boost stocks in the coming months while depressing bonds, investors say.
"We've got three months of market reaction to a more stable Europe," said Luke Hickmore, fund manager at Aberdeen Asset Management.
and Noemie Bisserbe contributed to this article
Write to Mike Bird at Mike.Bird@wsj.com
(END) Dow Jones Newswires
April 24, 2017 12:47 ET (16:47 GMT)