French Bonds Dip on Election Fears, Spread May Widen to 64bps

Key Takeaway

• French bond futures declined sharply amid political uncertainty from Macron's call for snap elections, with increased bearish exposure.
• The yield spread between French and German 10-year bonds is at 51 basis points, potentially widening to 64 basis points due to election risks.
• France’s longer-dated bonds are expected to underperform German bunds as traders price in a political risk premium.

French Bond Futures Slump

French bond futures experienced a significant decline this week, coinciding with a surge in turnover. This suggests that traders are adding fresh bearish exposure following President Emmanuel Macron's call for snap elections. The political uncertainty surrounding the upcoming parliamentary vote has led investors to bet on an extended decline in French bond contracts.

The steepening of the Treasury curve is also contributing to the downward pressure on French bonds. Traders are pricing in the risk of a hawkish Federal Reserve outcome after last week’s strong jobs report. This has led to a broader sell-off in global bonds, with early weakness in European bond futures adding to the risks from this week’s FOMC and BOJ meetings, as well as the upcoming US inflation report.

Yield Spread as Insurance

Investors anxious about the parliamentary vote in France are likely to use the Germany-France yield spread as an insurance policy against a messy election result. This will translate into further pressure on French bond contracts into early July, at least. The spread between French and German 10-year bonds is currently around 51 basis points, with the potential to widen to 64 basis points depending on the election outcome.

French President Macron's defeat in the European elections over the weekend has opened the door for further uncertainty. However, it’s not Macron’s leadership that is at stake, so any widening of the spread will likely be capped around this level. The risk premium being affixed to French securities will be pretty much complete at this point.

Underperformance of French Bonds

France’s longer-dated bonds are expected to underperform their German peers in the coming weeks as traders incorporate a political risk premium. French 10-year bonds currently offer a yield of 3.159%, about 51 basis points more than comparable German notes. Even traders looking for another ECB rate cut in July will focus on German bunds as a more secure vehicle for expressing their views.

The carry and rolldown profile of the two securities also plays a role. Holders of France’s 10-year debt face a negative carry but a positive roll, with the net effect being slightly more negative than 2 basis points per quarter. On bunds, the cumulative effect is more than a negative 3 basis points. However, over the short term, the political risk premium is bound to eclipse the greater negative carry and roll on German bonds.