Circling Hawks

It's Panic-Off for French Bonds

The ECB is far more important for the debt outlook.

Emmanuel Macron’s success in the first round of the French presidential election has seen the nation's assets kicking away the political fears of the past six months. If he does win the second round to become president, as the markets now fully expect, then a more unified Europe may well result.

However, it is France's equities that stand to gain most rather than debt markets, as they'd clearly been held back by the handbrake of political worries. Stocks had their best day in five years, climbing to the highest since 2008. French banks have been the major outperformers since Sunday night’s result, with some rising by as much as 10 percent, though they have the advantage of coming from a relatively cheap starting point compared to global peers.

Vive La France

The widest measure of French stocks is at highs last seen nearly 10 years ago

Source: Bloomberg

It's a different story for French bonds, which have long had the European Central Bank as their prop. With political risk evaporating, so might the support.

The spread between French and German 10-year benchmarks has tightened in by about 20 basis points since Sunday, but this is as much a story of German bunds rising in yield as French bonds falling. The must-have liquidity premium for German debt has reduced, with 10-year yields doubling in a week. The snapback is even more pronounced in the short end. 

Core Reunited

Panic premiums are receding for Germany as France regains its poise

Source: Bloomberg

This is more of a flight away from quality than a huge reinvestment into French debt. Domestic funds have taken profit from Macron's strong showing. Japanese investors, who were large sellers in the first quarter, may return with the lowering of political risk, but don't count on a big new influx of support.

The trouble is, there are not many bond bargains to be had. The spread to Germany has just about halved from its widest point. The French curve has negative yields out to five years, even the 10 year only offers a yield of 84 basis points. With yields like this, those who'd been bitten before would understandably be shy of rushing in.

With this much cooler political temperature, the ECB policy meeting on Thursday should see the hawks push for the Governing Council to drop its official assessment that risks in the euro area lie to the downside. That would take officials one inch closer to actually removing stimulus. And anyway the pullback has already started -- remember tapering began this month, with the target for quantitative easing purchases falling to 60 billion euros ($65.4 billion) from a previous monthly pace of 80 billion euros. 

Today's syndicated deal for the European bailout vehicle, the European Financial Stability Fund, shows there's been some improvement in investor demand for Europe. The EFSF has barely been seen at the long end since February, though on Apr. 4 it did achieve a 1 billion-euro add-on to an existing bond due in 2045. So the idea that it could add double that amount to a 26-year bond (it's also doing a 10 year) is a step forward.  It's attracted a lot of demand, but that's because it's cheap. The yields on offer are about the same as those for France, which is rather more than you'd expect, considering that the issuer also benefits from the backing of Germany.

Macron’s electoral progress is a genuine cause for relief, but his expected win in the second round offers little prospect for big upside for bonds. The ECB’s rate and QE outlook are more relevant for valuations now, and the outlook for support isn't quite so promising. Equities have far fewer barriers to the sunlit uplands. 

(Corrects to show that the EFSF added 1 billion euros to an existing issue due in 2045 on Apr. 4.)
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

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