Hollande Bond Rally Muffles S&P’s Wake-Up Call
Yield-hungry bond investors are giving French President Francois Hollande a free ride.
Buyers of French debt ignored a wake-up call from Standard & Poor’s last week that Hollande isn’t doing enough to address shortcomings holding back growth, such as high taxes and labor costs. At 2.3 percent, the 10-year yield has stayed at less than one percentage point from its record low after France’s rating was lowered by S&P on Nov. 8 to AA, the third-highest grade.
The market’s muted reaction reflects France’s deep and liquid bond market and efforts by the European Central Bank -- like its major counterparts around the globe -- to pump money into the system, capping yields in so-called core and semi-core markets. Trouble is, the low yields also diminish the urgency for Hollande to fix Europe’s second-largest economy.
“The market is more patient with France than ratings agencies are,” said Steven Major, head of fixed-income research at HSBC Group Plc, in London. “If the financing cost keeps going down, there is less impetus to act. The sad truth is that action has only come when the refinancing rates rose.”
Hollande himself immediately jumped on France’s low borrowing costs as evidence his policies are the right ones. The government is “doing everything” to reduce the deficit, improve competitiveness and create jobs, he said in a press conference less than four hours after the downgrade.
Although the French 10-year yield is close to its record low, it’s still attractive to investors given the 47 basis point premium it offers over German bunds and 20 basis points over comparable Finnish bonds. The French-German spread is down from a euro-era record of 204 basis points in November 2011.
The cost of insuring French government bonds against default fell to 51 basis points, the lowest in more than three years, after the S&P announcement. It rose to a record 261 basis points in November 2011.
“The French government’s current approach to budgetary and structural reforms to taxation, as well as to product, services and labor markets, will not substantially raise France’s medium-term growth prospects,” S&P said.
Investors have largely disregarded ratings downgrades. Since S&P’s first downgrade of France in January last year, French government bonds returned more than 10 percent, according to the Bloomberg France Sovereign Bond Index. France lost its AAA level at Fitch Ratings in July, after Moody’s Investors Service cut the country to Aa1 from Aaa in November last year.
The U.S. 10-year Treasury yield was 2.8 percent today, compared with 2.6 percent on Aug. 5, 2011, the day S&P stripped the country of its AAA rating. It dropped to a record low of 1.379 in July last year.
“In part this reflects a diminished power to shock on the part of ratings agencies since the global crisis began,” said Richard McGuire, head of European interest-rate strategy at Rabobank International in London. “It’s central bank liquidity that has been in the driving seat in terms of determining the euro-zone yield and spreads. This is why the ever-popular notion of shorting France versus Germany has remained very much the pain trade despite the convincing fundamental arguments.”
The French government bond market is the second biggest in the euro area, after Italy’s, and is the fourth largest in the world, according to data compiled by Bloomberg.
“France is and will remain a country whose credit is solid and that will continue to finance its debt at among the most attractive rates in the world,” Finance Minister Pierre Moscovici said on France Info radio on Nov. 8.
Those remarks provide cover against S&P’s real concern: that Hollande’s effort to revive the French economy is faltering in the face repeated protests against tax increases.
“It appears the market is pricing in very low risk of any significant difficulty in France in terms of a reform process,” said Robin Marshall, a director of fixed-income at Smith & Williamson Investment Management in London. “To me, that’s pretty optimistic. There are a number of fundamental issues that have gone into the background because of perception that the region’s economy is turning around and the ECB will continue to keep its policy accommodative. France is still a bit of a hidden landmine in my view.”
The Socialist president, whose popularity is at a record low, has faced increasing resistance as he seeks to raise taxes to trim the budget deficit. He decided last month to suspend a truck levy in the face of protests, two days after backing down on a plan to increase taxation on savings programs.
S&P cited the slow pace of reforms and a rigid economy that’s losing competitiveness relative to its northern European peers for its downgrade.
“France is also falling behind relative to Spain and Italy,” HSBC said in its note. “At a government level, more efforts to reduce expenditure are required as a disproportionate tax burden is stifling the economy.”
After pushing through a payroll tax cut and a loosening of labor market rules to make firings easier in the past year, Hollande hasn’t set out the next steps for fixing an economy that has barely grown for two years. Unemployment is at a 14-year high of almost 11 percent. Hollande’s mandate runs until May 2017, leaving him three and a half years to go.
“Momentum on reform dropped off last spring, leaving us with very little policy plans in the pipeline,” said Fabrice Montagne, an economist at Barclays in Paris. “This is the right timing for a wake-up call.”
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