The worst bond rout since the sovereign debt crisis. Companies are eager to lock in funds ahead of potential shortfalls. The stock market suffered nearly $200 billion in losses.
French President Emmanuel Macron’s decision earlier this month to hold early domestic polls in response to far-right victories across Europe upended markets across the region, triggering a sharp repricing that cost billions of euros. Constantly fluctuating.
On Sunday, investors will learn whether the selloff has room to continue.
The stakes are high. France’s fiscal integrity has been called into question, with investors betting against the country’s bonds even before Macron’s surprise decision, while the region’s appeal as a stable and relatively volatility-free alternative to U.S. markets has taken a hit.
David Zahn, head of European fixed income at Franklin Templeton, concluded: French bond spreads over German bonds could “easily” exceed 100 basis points from around 80 basis points now, which would It would have been unthinkable less than a month ago.
“There is nothing to win in this market,” said Stephane Deo, senior portfolio manager at Eleva Capital SAS, who has cut all the fund’s investments in France.
Traders heading into parliamentary elections at the weekend held the most French bond futures contracts in at least a year, a sign of their bets that yields will move higher. Stock pickers are hedging losses with the most put options pegged to Europe’s main blue-chip benchmark in two years. Currency traders rushed to buy derivatives to protect themselves from the euro’s fastest decline in 15 months.
The main concern across markets is that France’s new government will plunge the country deeper into debt. France’s deficit is already larger than EU rules allow, and a strong showing from both the right and left will be seen as increasing the government’s chances of further easing fiscal policy.
S&P Global Ratings downgraded the country’s credit score at the end of May, and the International Monetary Fund predicts that its deficit will remain well above the EU’s 3% ceiling in the coming years.
If banks end up being forced to step in and buy up bonds when foreigners exit, the pain for the bonds could translate into pain for the banks. With French banks already racking up losses at euro zone banks in June, the spread of the virus could spread beyond France by then, pushing up borrowing costs for weaker EU members.
A portfolio manager at Allianz Global Investors said recently that investors’ memories of the region’s debt crisis are still lingering and knock-on effects from France could once again call into question the entire euro project.
The last time Le Pen’s far-right party came close to taking power was in the 2017 presidential election, when they promised voters a referendum on whether the country should leave the euro zone. Although she has since softened her stance, her party’s policies still unnerve investors.
Risks of “French Brexit”
An indicator based on credit default swaps shows the likelihood of France leaving the EU has almost doubled since the European elections and is close to its highest level since 2017.
The question is “whether people are willing to go down the path of thinking about repricing,” said Erik Weisman, portfolio manager and chief economist at MFS Investment Management. “I think it’s unwarranted no matter what the outcome is. But the market may have other ideas.
Political unrest in France has cast a pall over the wider region.
Weakness in France’s sovereign debt has spread to Italy, Europe’s earliest poster child for fiscal profligacy. The spread of the epidemic in Germany has expanded to its highest level since February.
In credit markets, the risk premium French companies pay to borrow compared with their euro zone peers has jumped to its highest level since the run-up to the 2017 election. Prior to early voting, this cost had been lower.
If euro zone bank stocks fall, trading volumes in derivatives markets will also reach their highest level since 2016.
Banks are thought to be vulnerable to concerns about the country’s political future because they hold government debt and face weak economic decisions. While sovereign bonds accounted for only 2.4% of total French bank assets as of the first quarter, that number could climb if banks step in to buy as foreign investors flee.
“There is a problem”
“Market access is an existential issue for banks,” said Gordon Shannon, portfolio manager at TwentyFour Asset Management. “Periods of market stress can undermine the ability to raise new capital.”
To be sure, the volatility caused by the election is likely to dissipate quickly, with investors predicting that Le Pen’s party – if it does win the most seats – will proceed cautiously to increase her chances of running in the 2027 presidential election. France’s CAC 40 equity benchmark has performed well after most legislative elections over the past 30 years.
Surveys show that no party is likely to win an absolute majority after the vote, and former French President Hollande said this week that he would be prepared to form a new coalition to govern if the election results in a hung parliament.
Karen Ward, chief market strategist for Europe, the Middle East and Africa at J.P. Morgan Asset Management, sees weakness in French bank stocks as a buying opportunity. The next French government will be concerned about the chaos caused by British Prime Minister Liz Truss’s proposal for unfunded tax cuts in 2022.
“In a few months we will no longer be talking about French politics,” she said. “This is not 2011-2012, and none of these more populous parties advocated leaving the eurozone. This is about immigration, which is a thread we see in Western politics.
Yet the anxiety is palpable. The surge in political risk has prompted some portfolio managers to abandon buying European bonds as they expect their valuations to catch up with those of U.S. bonds.
This coincides with a shift in equity sentiment, where uncertainty ahead of Sunday’s vote has undermined Europe’s bullish outlook, prompting investors to cut exposure and rebalance their positions against U.S. assets.
Rate traders expect the country’s borrowing costs to remain high for the foreseeable future.
“French spreads are not going to return to pre-election levels anytime soon,” said Sonia Renoult, rates strategist at ABN Amro. “The question is how quickly it retreats and whether the bond market will Does the agency need to force it to do so?”
