The fall of French Prime Minister François Bayrou’s government may not have shocked investors (markets had long priced in political turbulence) but the implications for France’s economy and particularly for its debt markets are becoming increasingly clear.
With OAT spreads already wider relative to Bunds and BTPs, the immediate question is how President Emmanuel Macron will respond to yet another leadership crisis. While bond markets remain relatively calm, for France, political stalemate looks set to become the new normal.
Commenting on this development, Alex Everett, Senior Investment Manager – Rates Management, at Aberdeen, said:
“The fall of the Bayrou government had become an inevitability for markets, and French government bonds, known as OATs (Obligations assimilables du Trésor) had already moved wider relative to Bunds and BTPs. The real test is how President Macron responds now. The least bad option is to appoint yet another Prime Minister to try to break the political and economic impasse.
“Yesterday’s vote shows that the Assemblée Nationale remains as divided as ever. Meanwhile, the financial imperative is to pass a prudent, deficit-reducing budget, however unlikely that seems. At this stage, even a small reduction would be better than nothing. Confidence in the French economy is already at a low ebb, and the longer this situation continues, the greater the problem becomes.
“It is clear that France’s political quagmire will not be resolved this year, and perhaps not until the 2027 Presidential Election. This will likely keep OAT spreads elevated – at least around current levels – for months to come. We remain short OATs against peers.”
According to Liam O’Donnell who leads the fixed income team’s strategy on macro and rates at fund manager Artemis, “Bayrou was installed to pass a budget, and he failed. The political will to compromise to avoid disaster doesn’t exist because disaster hasn’t occurred in recent memory. We’re not in a debt crisis when 10Y French bonds yield 3.5%. But every time markets are presented with new evidence that a government can’t reign in deficit spending, it presents additional headwinds for long-term debt sustainability, not just in France, but globally.
“Whoever Macron appoints next to replace Bayrou has the same challenge – persuading factions of the hard and centre left that the debt crisis is going to need spending cuts.”
Michael Browne, Investment Strategist, Franklin Templeton Institute has also shared his analysis following this latest news from France saying:
“It comes as no surprise that Prime Minister Bayrou has lost the vote of no confidence and President Macron is now looking for his fifth Prime Minister since the start of 2024. The ill-judged election held this time last year merely compounded the political instability in a country running a fiscal deficit of over 5% and a debt to GDP ratio of 116% and rising. But without a political base in the Assembly (Parliament) to support either spending cuts or tax rises, there is no hope of resolution. But Macron’s sole political aim seems to be to prevent the Right-wing party of Le Pen, the RN, forming a government or providing the next President and therefore, the deficit can wait. September will see a series of strikes across the country organised by Left and Right but again, they will just be ignored, waited out.
“That judgement is probably right: France is backed by the EU, the ECB and the single currency, France is going nowhere. Its financial system is sound. Sure, it is the only country in Europe where spreads have widened against Germany but only by 80 bps. There will be no currency crisis and no funding crisis.
“So, whoever takes over, whether an old hand, a technocrat, a centrist or a left of centre (note it will not be from the hard left or the hard right) it will not matter. They will not be expected to achieve anything. Just muddle through to 2027 and hope that the improving economic situation in Europe, driven by the German Chancellor Mertz, sparks enough growth to offset the risks of not having a new budget for two years. The bond market is sanguine, but the equity market has struggled, not due to the politicians’ woes but the weakness of the luxury goods sales. A functioning government is clearly a luxury France will not be allowed and when it does, in 2027, the markets will be ready with their verdict.”
Also chipping in with his insights, David Roberts, Head of Fixed Income at Nedgroup Investments, has shared his comments on future of French Bond Market saying:
“For several years, bond markets were heavily manipulated by central banks. Not least under the guise of purported CPI targeting quantitative easing. Funnily enough, it took a supply side shock to rectify that damage. Who’d have thought reducing the cost of a commodity (in this case money) would reduce inflation? Keynes, for one – but that’s so 20th century.
“Of course, one could argue the role of central banks is in part exactly that – to manipulate bond markets and set an appropriate long-term cost of capital
“Since Mario Draghi’s infamous ‘whatever it takes’ comment, bond markets have assumed central banks would be there to offer support in time of crisis. The level of manipulation increased
“With French politics at an impasse, we are now hearing talk the European Central Bank could consider coming to the rescue. There are several avenues such support could take, not least direct bond buying via the Transmission Protection Facility.
“But should the ECB lend support? It’s been pointed out that, despite an AA credit rating, French bonds trade wide of those offered by either lower rated Greece or Portugal and are no longer dissimilar to BBB Italian debt. Surely, the market is unfairly punishing France?
“To an extent, ratings are backward looking, not least in times of flux. France has been under EU fiscal reform for some time and the Bayrou plan included budget reductions to reduce the fiscal deficit toward Brussels dictat. Current uncertainty seems likely to result in ratings downgrade.
“French bond yields may be higher relative to many EU nations. At around 3.5%, French 10-year yields are not far from longer term norms. Fiscal uncertainty is decidedly higher, suggesting higher borrowing costs are warranted, not the result of speculative forces.
“Is it surely wrong to reward France for self-inflicted failures, including failure to address budget shortcomings when other EU nations continue to progress toward Maastricht objectives? Those buying hoping the ECB will step in may be disappointed.
“Expanding the topic of manipulation, ECB interference isn’t a million miles away from what is happening on the other side of the Atlantic.
“Donald Trump isn’t so much seeking control of the Fed as he is trying to set (much lower) the cost of capital, especially long-term borrowing costs. After all, what’s better for real estate or long run equity valuation than cheap money? Well, maybe inflation.
“Europe and its central bank have on occasion expressed a ‘holier than thou’ attitude to all things Washington. Interference in French economics could easily be read as interference in French politics. Any monetary moral high ground and central bank standing can quickly be lost.”
Guillermo Felices, global investment strategist at PGIM Fixed Income, has shared his thinking too highlighting the potential fall-out risks for wealth managers to be aware of commenting:
“Despite the economic and political situation in France, demand for its government debt (OATs) hasn’t faltered, mainly reflecting that spreads to German debt already priced in the dire fiscal situation in France, as well as some of the downside risks that emerged following the announcement of the confidence vote. This largely explains why spreads didn’t move materially following yesterday’s no confidence result. Investors now await the appointment of a new prime minister. If the new PM is seen as bridging the divisions in parliament that are needed to pass a budget that helps consolidate fiscal policy, markets will likely remain resilient.
“At the moment, the main threats to French debt are threefold: a new PM that is not seen as market friendly (for example, someone who favours tax rises versus spending cuts); snap parliamentary elections that lead to more uncertainty about fiscal consolidation; and president Macron resigning. All of these would likely lead to wider spreads with Macron’s resignation being the most disruptive (but least likely), followed by a snap parliamentary election and finally a market unfriendly new PM.
“Investors will also be looking out for potential risk events in the coming days including the ‘Bloquons tout’ protest on Wednesday, which could indicate a sign of pressure on Macron, and Friday’s Fitch ratings, the first after the vote of no confidence.
“We see the risk of a highly disruptive outcome with major contagion to other European government bond markets (EGBs) as limited. This is because the macro backdrop in Europe is solid and the European Central Bank (ECB) has the tools needed to limit contagion, notably the Transmission Protection Instrument (TPI). While risks remain, France has found ways to muddle through political crisis in recent months and years. Spreads are also already pricing fiscal concerns and political turmoil. French spreads are consistent with a ratings downgrade and are wide relative to other EGBs with similarly high public debt.
“Given this backdrop and risks, we remain attentive to tactical opportunities that may open up in France and other EGBs. For long-term investors who can tolerate volatility, valuations are interesting. Curves are very steep – twice as steep in France and Italy compared to the US – and hedged yields are attractive especially for US investors.”
