France's Bond Roller-Coaster

The threat of a run-off between Melenchon and Le Pen is uniting both president and investors.

French President Francois Hollande isn't the only one starting to fear his successor will be decided in a run-off between Marine Le Pen and Jean-Luc Melenchon.

With 40 percent of voters still undecided, and four candidates polling within six percentage points of each other, bond investors are getting concerned too.

The spread in yield between French two-year government bonds and their German equivalents has widened to the most in almost five years.

Crisis Reprise?

The short-end French spread to Germany has widened to the most in five years

Source: Bloomberg

It's striking that yields on shorter-dated French government bonds have risen more sharply than their longer-dated counterparts over the past month.

France's Short-End Wobble

Yields on shorter-dated government bonds have jumped. The rest have fallen.

Source: Bloomberg

The front end is reacting more sharply as investors needing super-safe collateral move toward Germany or other core euro countries. When yields are negative -- as they already are in France for bonds of up to four years' duration -- there is simply no appetite for surprise risk.

The recent surge in popularity of hard-left candidate Jean-Luc Melenchon, to comparable levels with the center-right candidate Francois Fillon, has changed that dynamic.

Tightening Race

The race to succeed Francois Hollande is getting closer, according to the polls

Source: PresiTrack French elections poll

The prospect of a head-to-head between extreme left and extreme right candidates is no longer far-fetched. The four leading candidates are polling within the accepted three point polling margin-of-error. And we ought to have learnt from Brexit referendum and the U.S. election that the polls are far from reliable.

Emmanuel Macron may remain the most likely candidate to prevail but, with his support static at best, success is far from assured.

While most banks' trade recommendations expect Macron to succeed, Goldman Sachs has recommended that clients short French ten-year bond futures as a hedge if anti-establishment candidates were to perform well.

It's important to stress that they don't even need to win. If Macron prevails, he will need a decent margin of victory -- especially if he is to garner enough support in June's elections for the National Assembly.

Macron doesn't have an established political machine, so will be looking to bring deputies from other parties into his fold. A narrow win would make that outcome less likely and leave him as a lame duck president, incapable of delivering his planned economic reforms at home and in the European Union.

The French roller-coaster doesn’t stop next weekend. It's just gearing up for another two months of twists and turns. You can see why investors are hunkering down given there's such a big chance of an unsatisfactory outcome.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

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