As France and Germany diverge in the bond (https://www.ft.com/topics/themes /Sovereign_Bonds) market, with the difference in yields between the countries’ debt the greatest in more than three years, investors are being forced to consider three interlocking questions.
What are the potential implications of a French presidential election that remains too close to call? How much of the change in sovereign yields reflects politics, or is the real story an end to asset purchases by the European Central Bank? And, if country risks are shifting, what other reordering across the eurozone bond market beckons?
Politics has come to the fore as support for François Fillon (http://next.ft.com
/content/592b9012-ea1a-11e6-893c-082c54a7f539), formerly the frontrunner in this year’s two-stage presidential election, has collapsed following a scandal related to the legitimacy of payments to family members.
A mainstream candidate of the right, Mr Fillon had been the favourite to win the May run-off vote, after April’s initial round of voting. His drop in support may have given the far-right Eurosceptic candidate Marine Le Pen (http://next.ft.com/content /9854f5e4-ebc3-11e6-930f-061b01e23655) a better chance of victory.
Bond prices drop as market interest rates rise, and yields on French debt
(http://next.ft.com/content/8876d514-ec56-11e6-930f-061b01e23655) have been creeping upwards when compared with those of Germany, a sign of shifting investor preference, or even caution.
However Gilles Moec, European economist for Bank of America Merrill Lynch, says that while many investors are understandably focused on the risks of a populist who has promised to take France out of the euro, there is actually no candidate for the status quo among the three polling above 20 per cent — Ms Le Pen, Benoît Hamon and Emmanuel Macron.
“The presidential elections present an unusually stark choice, between pro-regulation,
and in some cases anti-European populism, and an untypical commitment to supply-side reforms from mainstream candidates and a more traditional leftwing candidate,” he says.
So one part of the calculation is potential for the French economy to accelerate as a result of policy changes or structural reforms. The yield on two-year debt remains negative, and benchmark 10-year bonds offered 1.14 per cent late on Monday, an annual income which would have seemed extraordinarily low before 2014.
Some also see the effect of central bank policy. The ECB has said it will cut the amount of securities it purchases each month to €60bn in April, from €80bn. The programme of quantitative easing is due to run until the end of this year, but one of the big debates on trading desks is whether higher inflation (http://next.ft.com /content/68b3a6b8-d26a-11e6-9341-7393bb2e1b51) and economic growth will prompt a further reduction in monthly buying.
Ioannis Sokos, interest rate strategist for BNP Paribas, says “ECB tapering has been a topic gaining traction, and it makes the QE impact less powerful”.
As bond markets started anticipating asset purchases in late 2014, bond yields across the eurozone converged ahead of the announcement of the programme at the start of 2015.
The reverse process may now have begun, with investors beginning to anticipate the removal of a weight that suppressed differences between the members of the
eurozone. A gap has also opened up between Spain and Italy, for instance, with buyers of the latter demanding a 60 basis point premium for benchmark debt.
Such movement prompts the final question, about the implications for borrowing costs across Europe.
France is a country of 65m, and a diverse economy likely to remain at the political heart of the EU. Its debt perhaps deserves to be less prized than that of Germany, long regarded as the safest choice of debt denominated in euros.
Yet another way to look at recent market movements would be that France has started
to be treated more like Ireland. On Monday morning yields on Irish and French two-year debt were both around minus 0.50 per cent.
For 10-year bonds, French yields were a mere 8 basis points below those of the Irish Republic.
Ireland has emerged from the depths of the financial crisis in better shape, but it
remains a nation of 4m people with longstanding political, cultural and
economic ties to a much larger neighbour, and one about to negotiate a disruptive exit from the EU. Credit rating agencies judge Ireland single A or lower, while France retains double A ratings.
Peter Goves, European interest rate strategist for Citi, says he would struggle to see French bond yields trade near or higher than Ireland “in a meaningful way” unless investors expect a “fundamental deterioration” in Europe’s second-largest economy.
Questions about the border with Northern Ireland, not to mention a longstanding peace agreement built on the assumption of UK membership of the EU, hints at the potential challenges ahead. US tax reform may also erode Ireland’s position as a location for the profits for large American companies.
It may be hard for bond investors to continue seeing little difference between Dublin and Paris.
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