French 10-Year Yields Surge, Spread Widens Post-Election

Key Takeaway

• French 10-year bond yields surged by 13 basis points after Macron's snap election announcement, widening the spread over German bonds to 56 basis points.
• S&P downgraded France's credit rating to AA-, citing a budget deficit increase to 5.5% of GDP and projected debt rise to 112% of GDP.
• Increased turnover in French bond futures indicates traders are adding bearish positions, anticipating further declines amid political and fiscal uncertainties.

French Bond Yields Surge

The yield on French 10-year OATs (Obligations Assimilables du Trésor) climbed by 13 basis points on Monday following President Emmanuel Macron's unexpected announcement of snap parliamentary elections. This move has introduced a significant degree of uncertainty into the market, causing the spread over comparable German securities to widen by 8 basis points to approximately 56 basis points. The elections, set to conclude on July 7, are expected to keep the market on edge, with the potential for the spread to widen further to 64 basis points.

Analysts are particularly concerned about the possibility of a victory for Marine Le Pen’s National Rally, which could push the spread to levels last seen during the 2017 French presidential election. According to Ven Ram, a Bloomberg analyst, "My OAT model, which has an overwhelming explanatory power of the movements in French securities, posits that the fair value of the 10-year maturity is 3.194%. The security is now trading at 3.224%, so the discount at which it is trading is just marginal at three basis points." This suggests that despite the recent sell-off, French bonds have not yet fully priced in the political risks.

Credit Rating Downgrade

Adding to the market's concerns, S&P Global Ratings recently downgraded France's credit rating from AA to AA-, citing the government's failure to contain the budget deficit. The deficit widened to 5.5% of GDP last year from 4.8% in 2022, and the ratings agency projects that government debt will balloon to 112% of GDP in three years, up from about 109% last year. This fiscal deterioration is expected to exert additional pressure on French bonds.

Mark Cranfield, another Bloomberg analyst, concurs with this assessment, noting that "French bond futures’ slump this week coincided with a surge in turnover, which suggests traders added fresh bearish exposure after President Macron called snap elections, betting on an extended decline." The combination of political and fiscal risks is likely to keep French bonds under pressure for the foreseeable future.

Market Reactions

The market's reaction to these developments has been swift. French bond futures have seen increased turnover, indicating that traders are adding bearish positions in anticipation of further declines. The steepening of the U.S. Treasury curve, driven by expectations of a hawkish Federal Reserve following a strong jobs report, has also added to the downward pressure on French bonds. Investors are likely to use the Germany-France yield spread as a hedge against a potentially messy election outcome, which will translate into further pressure on French bond contracts at least until early July.

Even traders who are expecting another rate cut from the European Central Bank (ECB) in July are likely to favor German bunds over French debt as a safer investment. According to Ven Ram, "France’s longer-dated bonds will underperform their German peers in the coming weeks as traders move to incorporate a not-so-inconsiderable political risk premium in the aftermath of the European parliamentary elections."