French President Emmanuel Macron’s decision earlier this month to meet the far-right’s gains across Europe with a snap poll at home has upended markets across the region, triggering a sharp repricing that’s put billions of euros in flux.
On Sunday, investors will find out if the selloff has room to run.
The stakes are high. France’s fiscal probity is in doubt with investors shorting the nation’s bonds even before Macron’s surprise decision, and the region’s allure as a stable and relatively volatility-free alternative to US markets has taken a blow.
David Zahn, head of European fixed income at Franklin Templeton, summed it up: The French spread over German bonds could “easily” blow through 100 basis points from around 80 now — unthinkable less than a month ago.
“There is nothing to win in this market,” said Stephane Deo, a senior portfolio manager at Eleva Capital SAS, who has cut all his fund’s exposure to France.
Traders are going into the parliamentary election at the weekend holding the most futures contracts on French bonds in at least a year, a sign they’re betting yields will go higher. Stock pickers are hedging losses with the most put options tied to Europe’s main blue-chip benchmark in two years. And currency traders are piling into derivatives that shield them from a drop in the euro at the fastest pace in 15 months.
The main fear for markets of all stripes is that the new French government drives the country deeper into debt. France’s deficit already exceeds what’s allowed under European Union rules and a strong showing by either the right or the left would be viewed as increasing the chances that the government loosens the purse strings further.
S&P Global Ratings downgraded the country’s credit score at the end of May and the International Monetary Fund predicts its deficit will remain well above the EU’s 3% limit for years to come.
Pain for bonds can translate into pain for banks if they’re eventually forced to swoop in and buy up the notes should foreigners head for the exits. With French lenders already leading losses among euro-area banks in June, at that point the contagion could spiral beyond France’s borders, driving up borrowing costs in the EU’s weaker members.
Memories of the region’s debt crisis are on investors’ minds, an Allianz Global Investors portfolio manager said recently, and ripples from France could once more bring the entire euro project into question.
The last time Le Pen’s far-right party came close to clinching power was in the 2017 presidential election, promising voters a referendum on whether the country should leave the euro. While she’s tempered her stance since, her party’s policies have investors on edge.
‘Frexit’ Risk
A gauge based on credit default swaps that indicates the likelihood of France leaving the EU has almost doubled since the European elections to near the highest since 2017.
The issue is “whether people want to go down the path of ruminating about redenomination,” said Erik Weisman, portfolio manager and chief economist at MFS Investment Management. “I think that would be unwarranted almost regardless of the outcome. But the market may have other ideas.”
Political ructions in France are already casting a shadow over the broader region.
Weakness in French sovereign bonds has spilled over to Italy — Europe’s original poster child for fiscal profligacy. There, the spread to Germany has widened to the highest since February.
In credit markets, the risk premium French companies pay to borrow compared to their euro-area peers has jumped to the highest since the run-up to the 2017 election. Before the snap vote was called, that cost had been consistently lower.
And trades in derivative markets that pay out if euro-area bank stocks decline have hit the highest since 2016.
Banks are seen as vulnerable to concern about a nation’s political future through their holdings of government debt and their exposure to weak economic decisions. While sovereign bonds accounted for just 2.4% of French banks’ total assets as of the first quarter, that number could creep up if lenders step in to buy as foreign investors flee.
‘Existential Issue’
“Market access is an existential issue for banks,” said Gordon Shannon, portfolio manager at TwentyFour Asset Management. “Periods of market stress curtail the ability to raise fresh capital.”
To be sure, volatility triggered by elections can dissipate fast, and investors predict Le Pen’s party — if it does win the most seats — will tread carefully to boost her chances for the 2027 presidential vote. France’s CAC 40 stock benchmark has done well after most legislative elections in the past 30 years.
Surveys indicate it’s unlikely any one party will have an absolute majority after the voting, and Former French President Francois Hollande indicated this week that he’d be ready to build a new coalition to govern if elections deliver a hung parliament.
Karen Ward, chief market strategist for EMEA at J.P. Morgan Asset Management, sees the weakness in French banks as a buying opportunity. The next French government will be mindful of the chaos triggered by unfunded tax cuts proposed by UK prime minister Liz Truss in 2022.
“In a couple of months’ time we will not be talking about French politics at all,” she said. “This is not 2011-2012, none of these more populous parties are advocating leaving the euro. This is about migration, which is a thread we are seeing in politics across the west.”
Yet the sense of angst is palpable. The spike in political risk has prompted several portfolio managers to abandon the practice of buying European bonds in anticipation of a catch-up with valuations in US debt.
That chimes with the shift in equity-market sentiment, where uncertainty before Sunday’s vote has derailed the bull case for Europe, pushing investors to trim exposure and rebalance their positioning toward US assets.
And rates traders are expecting the nation’s borrowing costs to remain high for the foreseeable future.
“The French spread won’t go back to its pre-election level anytime soon,” said Sonia Renoult, a rates strategist at ABN Amro. “The question is how quickly it pulls back and whether the bond market or institutions need to force it to do so.”
