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

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

Bonds
Althea Spinozzi

Head of Fixed Income Strategy

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.

Political risk.

We believe that the political risk ensuing from the French elections is overly exaggerated by markets.

The country’s fiscal recklessness was under scrutiny even before the current political turmoil began. Last month, S&P Global Ratings downgraded France’s sovereign rating from AA to AA-, as the agency sees government debt likely to rise to 112% within the next three years, up from 109% at the end of 2023.

At the same time, French politicians seem careful not to upset financial markets as the RN party is planning a two-phase reform to reassure markets amid France's high public debt. Some major policies, like reducing the retirement age to 60 for some workers and a EUR 7 billion VAT cut, may be delayed.

Rating downgrade risk.

A rating downgrade can be concerning as it signal fiscal instability or economic problems, leading to reduced confidence among investors, both domestic and international.

Holders of French government bonds, may sell off their holdings of downgraded bonds, leading to capital outflows, and an increase in bond yields. This fear is further consolidated by the fact that more than half of the publicly traded French government debt is owned by foreign investors. Foreign investors, while adding diversity and potentially large capital flows to a country's government bonds, are often more sensitive to global financial conditions and currency risk, making them more likely to withdraw their investments during periods of volatility. Their decisions can be influenced by external factors such as geopolitical events, changes in global interest rates, and economic conditions in their home countries. This susceptibility to external shocks can lead to sudden capital outflows, increased market volatility, and liquidity issues. 

Interest rate risk.

At this crossroads, French fiscal sustainability concerns seem unlikely to be exacerbated by the ECB's hawkish stance. Policymakers are considering further rate cuts, with Olli Rehn recently stating that he still envisions two interest rate cuts by the end of the year. This approach will support French government bonds, as the ECB appears to have entered a rate-cutting cycle, albeit a gradual and slow one. However, if rate cuts are postponed, government bond yields are likely to rise broadly across eurozone countries. This scenario would lead to increased volatility in French government bonds, especially if it coincides with a National Rally (RN) victory.

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