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Updated from May 29

On Sunday, France rejected a referendum on the European Union constitution. Recent polls had indicated that those favoring a rejection had a slight lead. In order for the constitution to be adopted, all 25 EU members must approve it. The rejection by the French then threatens the entire process and, according to conventional wisdom, the value of the euro.

Coupled with the fact that the global capital markets are thin Monday due to holidays in the U.S. and U.K., there would seem to be potential for a volatile market reaction to a "no" vote.

Indeed, the euro fell against the dollar in European trading, recently fetching $1.2502 in London, down from $1.2584 late Friday in New York. Against the yen, it fell to 134.83, from 135.79.

Don't Panic

Yet I suspect that the situation is a bit more complicated than simply selling the euro, since the French rejected the constitution. In fact, a knee-jerk dollar bounce in response to the French rejection of the EU constitution might provide the savvy trader a good opportunity to either liquidate long positions or go short.

First, the market may not be so ill-prepared for a French rejection after all. The most recent Commitment of Traders Report from the Commodity Futures Trading Commission found that the speculative community has the largest long-U.S.-dollar exposure in several years. This, coupled with the euro's recent decline, may reflect some positioning for a no vote.

Second, the rejection of the constitution might not really be the earth-shattering event many partisans are claiming. The lack of a new constitution would mean the continuation of the status quo. It means that the EU lacks a strong executive and lacks a single voice for foreign policy. It means that the basic governing structure of the EU will be reformed, even though its membership increased markedly.

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The defeat of the constitution could mean that further enlargement into Eastern Europe and Turkey becomes more difficult. Partly, a defeat of the constitution could reflect the fatigue of enlargement, as 10 new countries joined last year, and there is already concern that the new entrants are taking the job of "Old Europe," as U.S. Defense Secretary Donald Rumsfeld put it.

Local Politics

The euro itself is best understood as an economic solution to a political problem. That political problem was convincing Europe not to obstruct the unification of Germany when the Berlin Wall came down. The economic solution was to share the mark and the Bundesbank's anti-inflation credibility with Europe, integrating the German economy even more into Europe. Despite this fact, the French public accepted the euro with only the slimmest of margins.

The French rejection of the constitution is probably also just a vote of protest against President Chirac and Prime Minister Jean-Pierre Raffarin. Both men are vocal supporters of the constitution. And both are increasingly unpopular in France. Recent polls put Chirac's support near an eight-year low and Raffarin can count on support from less than one in four.

French unemployment stands at more than 10%, little changed from when Chirac was first elected 10 years ago promising reform. The economy grew 2.4% last year, with the help of the lowest interest rates in modern times and a budget deficit that has been in excess of 3% of GDP for three years, seemingly in violation of the Growth and Stability Pact agreement.

The French rejection likely will have significant ramifications for domestic politics. Raffarin most likely will be forced to resign. Already unlikely to be re-elected in 2007, Chirac will be the lamest of ducks.

Outlook: Euro in June

Even if the rejection of the constitution stalls the progress toward further enlargement, the next seven-year EU budget and the liberalization of trade services, it is not the stuff that is ultimately salient for foreign exchange traders.

This year likely will be the 13th of the past 14 that the U.S. economy expands faster than the EU's. A change in how the EU makes decisions, which is a new constitution, is unlikely to alter this structural pattern.

As noted previously, the speculative community already has established a significant long-dollar position. Another indicator that I see as contrarian is that in recent weeks many investment houses have revised up their forecasts for the dollar. And this after the dollar has defied most expectations and strengthened to multimonth highs against the euro, Swiss franc and British pound.

It may reflect a bit of chasing the market. I would add to this that the popular press also has begun noticing that rather than fall, the dollar has risen. This seems like a sign that the party, at least in the near term, is getting kind of late.

Oh, I still maintain that as the

Federal Reserve

continues to raise U.S. short-term interest rates and the U.S. yield curve flattens, the dollar will find more and better traction. But in the near term, a lot of good news has been discounted, and given the market positioning, it is vulnerable not just to bad news, but to as-expected news.

Admittedly, most technical indicators have yet to turn positive for the euro. Yet, given the market positioning, the contrarian indicators and the anticipated fundamental developments outlined above, I suspect the euro can recover toward the $1.2730-$1.2760 area initially and possibly even the $1.2800-$1.2820 area in June. On the downside, I envisage the euro has potential to drop toward $1.2430-$1.2450 in response to the French rejection of the constitution.

Marc Chandler says the situation is a bit more complicated than simply selling the euro because the French rejected the EU constitution Sunday. In order for it to be adopted, all 25 EU members must approve it, so the rejection by the French threatens the entire process and, according to conventional wisdom, the value of the euro. But Chandler says a knee-jerk dollar bounce in response to the French rejection of the EU constitution might provide the savvy trader a good opportunity to either liquidate long positions or go short.