Aug. 1 (Bloomberg) -- Investors who bestowed record-low borrowing costs on France will find out if their fidelity is warranted when President Francois Hollande presents his 2013 budget next month.
As Hollande’s government prepares today to leave on a two-week summer break, his deficit-cutting promises and the market’s hunger for yield are helping French bonds beat their European AAA counterparts. They returned 3.4 percent in July, more than double Germany’s 1.4 percent, becoming the region’s best performers after Belgian securities.
“An armed peace is a good way to describe the situation,” said Philippe d’Arvisenet, global economist at Paris-based BNP Paribas SA. “No one sees France defaulting, and markets trust the government. They’re willing to wait and see if it will stay on track with its deficit promises in the 2013 budget plan. If the government doesn’t present something credible, yields will go higher.”
Hollande’s 2 ½-month-old Socialist government has been rewarded even though its deficit-cutting efforts have focused more on raising taxes than capping public spending. The extra yield investors demand for holding 10-year French debt relative to German bunds fell to 70 basis points from 112 on July 5, when the European Central Bank lowered its deposit rate to zero.
“Semi-core bonds have done well on the back of the deposit rate cut and a hunt for yield,” said Richard McGuire, a fixed-income strategist at Rabobank International in London. “That benefits French and Belgian bonds.”
The rally in French bonds may peter out later this year as Hollande faces the real test of his deficit-cutting resolve when his government presents its first full-year budget in late September. The yield on 10-year French bonds, which fell to a record low of 2.019 percent today, may rise to 3.05 percent by end-December, according to the median forecast of six analyst estimates compiled by Bloomberg.
Still, in the near term, French bonds, or OATs as they are called for their French acronym, may gain even as their safe-haven status is dented when ECB President Mario Draghi unveils his plan to ease borrowing costs in Spain and Italy.
Draghi sparked a global market rally last week by pledging to do whatever it takes to preserve the euro. He is trying to build consensus among governments and central bankers before ECB policy makers convene tomorrow.
“Since France is the most exposed country to peripheral bonds in terms of the banking sector, France will benefit because it brings more home in terms of liquidation of peripheral investments and repatriation into OATs,” Rabobank’s McGuire said.
French banks had $534 billion in public and private debt holdings in Italy, Spain, Greece, Portugal and Ireland at the end of March, the most for any country, Bank for International Settlements figures show. France was stripped of its AAA rating by Standard & Poor’s in January.
Whatever aid is given to Spain and Italy, “I doubt it will markedly affect demand for French bonds,” said Christoph Kind, head of asset allocation at Frankfurt Trust. “Demand for safety is likely to stay strong. And if the new measure is indeed a game changer as expected by the market, it should benefit the euro and that should be good for France as well.”
Draghi’s pledge came after the yields of Spanish and Italian securities soared and fueled speculation the monetary union could fall apart. The Spanish 10-year yield jumped to 7.5 percent and comparable Italian yields approached 7 percent.
“People are still concerned about the French budget, but more negative headlines seem to come out of Spain than France,” Kind said. “The market now makes a clear distinction between the core countries, which includes semi-core like France and Belgium, and the periphery.”
With a ratio of debt to gross domestic product about 30 percentage points higher than France’s, Italy’s battle is a tougher one. Recessions in Italy and Spain shrink their tax base, feeding a “vicious circle” that’s accelerating the increase in its cost of borrowing, BNP’s d’Arvisenet said.
By contrast, Hollande’s commitment to focus on deficit and debt reduction worked pre-emptively on markets, averting a focus on “putting out fires,” he said.
Since his May election, Hollande has relentlessly reiterated his commitment to cut the nation’s debt and deficit, saying they erode France’s ”sovereignty.” He has kept former President Nicolas Sarkozy’s target of cutting the deficit to 4.5 percent of gross domestic product this year and 3 percent next year from 5.2 percent in 2011.
“The market had probably priced in too much pessimism about Mr. Hollande,” said Johannes Jooste, a senior strategist in London for Merrill Lynch Wealth Management, which manages $1.8 trillion globally. “I think the economic reality is going force his hand to be a lot more conventional than his pre-election rhetoric suggested. If you look at how much risk the French sovereign carries, I would say a bit more than Germany, but certainly not a substantial amount. French debt is a reasonably place to be.”
In his televised Bastille Day interview on July 14, Hollande said that ”efforts” and ”patriotism” are required. His plan calls for state spending cuts and higher taxes for the wealthy and for CAC 40 companies.
The proposals come as France’s economy, Europe’s second-largest, probably contracted in the second quarter for the first time since 2009 and with the jobless rate at a 13-year high.
“The danger for France is that it lets itself be blinded by its honeymoon period and forgets that it must go the extra mile on reforms,” said Bruno Cautres, a political analyst at Cevipof, a research center in Paris.