The French election is a big deal — and it has more than one scary outcome for markets

France's presidential election is a major test for euro zone unity, and the first round Sunday could bring on intense market volatility, depending on which candidates make it to the final leg of the race.

French stocks closed down 1.6 percent Tuesday, after recovering from the worst intraday selloff since the U.K. voted to leave the European Union last June. Investors globally have been hedging ahead of the vote by piling into safe haven assets like U.S. Treasurys and gold, and buying yen against the euro.

"I think it's potentially huge, or it could be nothing, and we'll know that Sunday night before the market opens," said Andrew Brenner, global head of emerging market fixed income at National Alliance. He said the spread between French and German 10-year bonds continues to widen, a signal of market unease.

The big fear is that far-right National Front candidate Marine Le Pen will win, since she has run on a platform to divorce France from the euro — an action that could threaten the future of the entire euro zone. As it stands now, there is a good chance Le Pen will emerge from the first round pitted against one of three candidates: far-left candidate Jean-Luc Melenchon, conservative Francois Fillon and centrist Emmanuel Macron, a former economy minister.

"It is true that four candidates are coming all within a margin of error. It is impossible to know for sure whether the French electorate will look at these polls and decide to vote with their hearts or get excited by the underdogs," said Charles Lichfield, associate, Europe at Eurasia Group. "Something we can say is Mrs. Le Pen is most likely of those four candidates to make the second round. They're all between 18 and 22 percent. Ninety percent of Mrs. Le Pen's 22 percent will vote for her."

The candidate favored by markets is Macron, who is expected to beat Le Pen in the final vote. "If it appears Macron is in the race, all of this goes away for the near term," said Brenner.

The disruptive candidate not named 'Le Pen'

However, Lichfield said Melenchon also stands a chance to win. Like Le Pen, he would be considered a disruptive candidate. A fan of Venezuela's Hugo Chavez, he would like to tax individuals who earn 400,000 euros ($430,000) or more at a tax rate of 100 percent. He also would like to renegotiate France's relationship with the European Union, and if it fails, he would seek to leave the EU.

"Depending on how high [Le Pen] is, the market could react quite violently. If her runner-up is 6, 7 points behind her, many people would see that it's possible she wins," Lichfield said. The runoff election is set for May 7.

"You hear people saying if Le Pen gets elected, France pulls out of the euro and the EU collapses. That's utter nonsense. For France to pull out, there has to be a vote of Parliament and they're overwhelmingly against leaving the euro," said Robert Sinche, chief global strategist at Amherst Pierpont.

There is a parliamentary election in June, and it in fact could be the more important election. Le Pen's far-right National Front isn't seen making much in the way of inroads.

   
"I still expect Macron and Le Pen to be in the runoffs," said Marc Chandler, chief foreign exchange strategist at Brown Brothers Harriman. "A lot of people think the French election is about the presidential election. It's also about the parliamentary election in June. The president is a figurehead. The problem is none of the candidates have a strong parliamentary presence. The key to the outcome is going to be the parliamentary elections. Political risk is going to subside, but it can't go away."

Chandler said a Le Pen victory could foster other nationalist groups in Europe, but it could also be a problem for Italy. Germany also has an election later this year.

"The key would be not so much the German election, but the Italian election," he said. Italy, under Prime Minister Paolo Gentiloni, has undertaken steps to provide emergency liquidity guarantees and capital injections for its banks. Former Prime Minister Matteo Renzi resigned in December, after Italy voted down a key constitutional referendum.

Watch: The French right comes out of hiding

The views on how France's election could affect markets diverge as much as do potential outcomes.

Lichfield said he sees a 35 to 40 percent chance for Le Pen to win. He said there are very slight odds, perhaps 10 percent, that financial market chaos erupts after the election. It could be so volatile it would send French yields skyrocketing and hurt the country's banks.

The long-shot scenario could even be extended to consider a French default at which point, France could be forced to leave the euro zone, Lichfield said.

More likely is that European Economic and Monetary Union officials keep the situation under control and panic does not set in. Even so, a Le Pen win would not be a positive.

"It will be negative because there's this now complacent view that Brexit wasn't so bad. Trump hasn't been so bad, so why are we worried about Le Pen? But if you look at what she wants to do, if suddenly the market slowing into what her actual policies are and realize she's right at the center of a vulnerable monetary union, then it becomes much more troubling," said Lichfield.

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By Patti Domm

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