Bond Market Update: Market Awaits First Round of French Election Voting.

Summary:

• As the first round of French election voting nears, the OAT-Bund spread may tighten if uncertainty about a National Rally victory grows. Further widening is possible but likely limited, as much negative news is already priced in.
• As the OAT-Bund spread reaches its highest level since the European sovereign crisis, we believe French political risk is overstated, particularly with the ECB entering an interest rate-cutting cycle.
• The biggest risk for French government bonds stems from the fact that foreign investors hold more than half of the country’s tradable securities. In the event of additional rating downgrades, foreign investors might look to sell these securities, exacerbating fiscal pressures.

This summer, Europe is in the global spotlight.

From a macroeconomic perspective, the ECB’s decision to cut interest rates in June is notable, as it comes at a time when inflation remains well above the ECB's 2% target and wage growth is sustained. Typically, interest rate cuts are a response to a recession or severe crisis, but in this case, the eurozone economy is showing signs of slight recovery. These pre-emptive rate cuts highlight the ECB's confidence in its forecasting abilities and its proactive approach to ensuring a soft landing for the economy, and it positions European sovereign bonds to more likely outperform U.S. Treasuries.

On the political front, fears of significant gains by far-right parties in the European elections have not materialized. However, the elections have had considerable implications for Germany and France. In Germany, Chancellor Scholz's center-left Social Democratic Party (SPD) finished third, reflecting a lack of voter confidence and weakening the current government. In France, the European elections led to President Macron calling a snap election after his coalition finished second, securing less than half the votes of the far-right National Rally (Rassemblement National - RN).

France’s credit-default swap spread surged after President Macron called snap elections and remains elevated. The yield premium on France’s 10-year bonds over their German counterparts has increased to around 80 basis points, up from 50 basis points at the beginning of June. Spanish government bonds, rated lower than France's, offer an additional 10 basis points over France and with a yield of 3.25%, French OATs now pay the third-highest yield in the eurozone, after Italy and Greece.

At 80 basis points, the OAT-Bund spread is the widest it has been since the European sovereign crisis in 2012. As the first round of voting approaches this weekend, the OAT-Bund spreads may tighten if uncertainty about a National Rally (RN) victory grows. While a further widening of the spread is possible, it is unlikely to increase significantly, as much of the negative news is already priced in. With leaders of the RN party trying to calm markets assuring that they won’t let the deficit running out of control, it’s unlikely that even in a RN victory will drive the OAT-Bund spread above 100bps, a level seen only during times of distress.