France Now Has to Face Bond-Market Risk It Prefers to Ignore

(Bloomberg) -- A political shock in France has forced bond investors to confront the reality that the nation’s fiscal deficit is an issue for here and now, not years down the road.

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The country has long benefited from investors dismissing the threat posed by its poor public finances given its core position within the euro area.

That calm is now at risk.

First, President Emmanuel Macron’s decision to call snap elections led the gap between French and German bond yields to widen to the most since the sovereign debt crisis by bringing into question the country’s political stability, eroding the cover afforded by his pro-business policies.

Now, with a hung parliament the result of that vote, any new French government will struggle to drive more economic reforms or find common ground on fiscal policy, with seemingly irreconcilable divisions when it comes to taxes and government spending.

Just look at the yield premium investors are demanding to hold French bonds over safer German securities: It hovered around 40 to 50 basis points before Macron dissolved parliament last month, and is now trading just below 70 basis points, even after markets expressed relief that neither the left nor the far right will have a majority.

Societe Generale SA says the spread has likely entered a new, higher range, especially because the left alliance was the surprise winner in the vote. French bonds were swept up in a global selloff on Tuesday, pushing yields on 10-year notes up by as much a 10 basis points, unwinding all of Monday’s gains.

“Gridlock deserves a premium because it leaves France more vulnerable to any additional external shock, and I think we’re being a bit complacent on assuming Macron can outplay the left bloc,” said Gordon Shannon, portfolio manager at TwentyFour Asset Management.

Shannon has plenty of company: Nuveen, one of the world’s largest investment managers, says it’s still not comfortable stepping in given such high uncertainty. MFS Investment Management says “sell rallies” in the French yield spread over Germany. UBS Global Wealth Management prefers countries with a more stable debt trajectory.

The next test of investor appetite for French debt comes July 18, when the French Treasury sells medium-term securities. That’s the same day the new National Assembly meets for the first time.

The French ructions are already raising questions over whether yields are properly compensating bondholders at a time of great flux, with electorates around the world taking out their frustrations by voting in politicians who’ve curried favor with unorthodox fiscal policies.

Worrying debt metrics can look downright dangerous in a heartbeat, a reminder that investors overlook the economic, political and social currents of individual nations at their peril.

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Credit Risk

Moody’s Ratings said in a note Monday that it could put a negative outlook on France’s credit assessment if it concludes that the new political situation will lead to materially worse debt outcomes. The firm has France on an Aa2 rating with a stable outlook.

“A weakening commitment to fiscal consolidation would increase downward credit pressures,” analysts including Sarah Carlson wrote in their report. Also, a reversal of some Macron policies, such as labor market liberalization and pension reform, would be negative if they hurt France’s growth potential or fiscal trajectory, they said.

Beyond France, the past month has hammered home the fragility of bond markets in places such as Italy, where spreads also have widened, and the US, where traders are betting on inflationary stimulus.

“With many voters opting for a different political approach, we can expect some of the established goal posts to be moved, particularly as the world around us is getting more volatile, complex, challenging and dangerous,” said Jan Lambregts, head of financial market research at Rabobank.“Markets may show a bigger interest again in the debt metrics of individual countries. Exhibit A is France.”

What Bloomberg Economics Says...

“What is clear is that with an expected deficit of close to 5% of GDP in 2024 and debt at around 111% of GDP, France is starting from a strained fiscal position, and left-wing parties will not be willing partners in fiscal consolidation.”

—Eleonora Mavroeidi, Maeva Cousin and Jamie Rush. For full note, click here.

France was already on a collision path with the European Union, which is starting to clamp down on member states in breach of fiscal rules. Whatever government emerges will have to immediately begin negotiations on a new path to get the budget deficit below 3% of economic output.

Macron’s government had already penciled painful spending cuts to get the gap to 5.1% this year from 5.5% in 2023. But those measures are likely off the table as all the parties that might be in a position to join the next government have promised increased spending.

Think tank Institut Montaigne estimates the pledges of leftist New Popular Front would require nearly €179 billion ($194 billion) in extra funds per year, and even the program of Macron’s party would incur extra spending of close to €21 billion.

“The cat’s out of the bag as regards to fiscal deficits and the risk associated with that,” said Orla Garvey, a portfolio manager at Federated Hermes. “If we’re left with weaker governments that are less able to enact the changes they need to make in order to improve the debt trajectory, that’s going to be a difficult environment for spreads.”

Global Problem

Around the world, sovereign debt piles have been rising for years, ballooning as governments tried to shield economies from the impact of the pandemic and inflation. While it was easy to turn a blind eye when interest rates were low, the challenge of refinancing and servicing so much debt is now causing much greater concern.

At the same time, a higher cost of living and issues like immigration are pushing voters toward populist and nationalist parties, which frequently tout additional borrowing as the solution.

“It’s the worst of both worlds,” said Guy Miller, chief market strategist at Zurich Insurance Co. “You’re seeing debt levels at worryingly high levels, and at the same time you’re having populist parties leading or winning in the polls, promising further spending.”

The US, long granted a pass by investors thanks to the dollar’s reserve status, is increasingly a cause for concern. A deficit nearing $2 trillion has left the bond market vulnerable to shocks, a risk that would only mount if Donald Trump retakes office in November. Yields on benchmark 10-year Treasuries have climbed recently when it looks like the odds are tipping further in his favor.

The UK has already experienced first hand just how quickly market sentiment can turn. Liz Truss served just 49 days as prime minister in 2022 after her plans for sweeping unfunded tax cuts sent shockwaves through the gilt market. The new Labour government has repeatedly told markets it will seek to exercise fiscal discipline.

The UK crisis is an effective cautionary tale. In Italy, where debt is nearly 140% of output, investors initially took fright when Giorgia Meloni was elected on fears that she’d ramp up borrowing. Since then, she’s trodden a more conservative path than expected, helping Italy’s bond spread over Germany touch a two-year low in March.

Back in France, the challenge will be finding a way of muddling through. Efforts to strike deals have gotten off to a bad start, with the left saying from the outset that they won’t back down on core pledges to reverse pension reform or indexing wages to inflation.

Nicolas Forest, chief investment officer of Candriam, warned that the closely watched yield spread over Germany could pass the recent peak of 86 basis points.

“The question is about the medium-term: what can we expect in terms of policy? What can we expect about the deficit?” he said. “France has become the weak man of Europe.”

--With assistance from Naomi Tajitsu, Sujata Rao and James Hirai.

(Updates prices in sixth and seventh paragraphs.)

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