French, Italian Bond Turmoil Dents Bank Stocks, Euro Stoxx Low

Key Takeaway

• French and Italian bond selloff, driven by political uncertainties, has led to a significant drop in bank stocks, with Credit Agricole and CaixaBank falling 4%.
• The Euro Stoxx Banks index hit its lowest since April due to the selloff; investors are moving towards safer assets like German bunds.
• Yield on 10-year French OATs rose by 13 basis points post-Macron's snap election call, widening the spread over German securities to 56 basis points.

Bond Market Turbulence

The bond markets in France and Italy have experienced significant volatility recently, driven by political uncertainties and economic factors. Speculation surrounding French President Emmanuel Macron's potential reaction to a possible defeat by Marine Le Pen’s National Rally party in the upcoming French legislative elections has led to a selloff in bonds. This has had a ripple effect on bank stocks, particularly those in France and Italy, which are major holders of government bonds.

The Euro Stoxx Banks index has dropped to its lowest level since April, with French and Italian banks leading the decline. Notably, Credit Agricole and CaixaBank, both significant holders of Italian government bonds (BTPs), have seen their shares fall by 4%. The selloff has also led to a decline in Bund yields, indicating a flight to quality among investors.

A recent poll showed Le Pen’s party garnering 34% of voter intentions in the first round, compared to 19% for Macron’s party. If these intentions translate into seats, Macron would have fewer seats, while Le Pen would gain significantly, though still short of a majority. French legislative elections take place over two rounds, making it difficult to predict the final outcome from initial polls.

Impact on Bank Stocks

The selloff in French and Italian bonds has had a pronounced impact on bank stocks, which have been one of the best-performing equity sectors this year. Italian banks, in particular, are large holders of Italian government bonds, making them vulnerable to any widening in BTP spreads. Credit Agricole, CaixaBank, and BBVA, all significant holders of BTPs, have been among the biggest losers in the market.

Technical indicators suggest that bank stocks may be slightly oversold. They are below the lower Bollinger band and are about to dip below 30 on a nine-day Relative Strength Index (RSI), though not on a 14-day RSI. However, this is not hugely significant as stocks can continue to fall. The breadth on the index is not as negative as it was last week, indicating some resilience.

Despite the selloff, it is important to note that any rumors around Macron’s plans are highly speculative. There is no constitutional reason for the president to quit if he loses control of the national assembly. While it is uncommon to have a president and a prime minister from different political groupings, it is not unprecedented.

French Bond Market Dynamics

French bond futures have slumped this week, coinciding with a surge in turnover. This suggests that traders are adding fresh bearish exposure following President Macron's call for snap elections. The steepening of the Treasury curve, as traders price in the risk of a hawkish Federal Reserve outcome after last week’s strong jobs report, has added to the downward pressure.

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 is expected to translate into further pressure on French bond contracts into early July. Even traders anticipating another European Central Bank (ECB) rate cut in July are focusing on German bunds as a more secure vehicle for expressing their views.

The yield on 10-year French OATs climbed by 13 basis points on Monday after Macron's announcement, while the spread over comparable German securities widened by 8 basis points to about 56 basis points. With France heading into two-phase polls concluding on July 7, uncertainty about the outcome is likely to persist, potentially widening the spread to 64 basis points.