Euro Rally Pushes French Linkers to Zero From Hero: Euro Credit

The euro’s rally has found a casualty: French inflation-protected bonds.

France’s index-linked debt, which beat its core-market peers in 2012, is trailing counterparts from the euro-region and the U.K. this year. The country is the only advanced economy in Europe where such bonds underperformed nominal securities.

Morgan Stanley recommends investors sell the 10-year French securities against regular bonds, betting on expectations for slower inflation, and buy so-called linkers in the U.K. as sterling weakness accelerates price increases.

“Investors should consider currencies when they think about a country’s inflation profile,” said Anton Heese, the global head of inflation strategy at Morgan Stanley in London. “The euro is being supported by a decline in risk conditions rather than economic fundamentals. Cross-market, it would seem to make sense that currency fluctuations will lead to higher inflation in the U.K. than in the euro zone.”

The euro has risen 10 percent on a trade-weighted basis since European Central Bank President Mario Draghi pledged in a speech in London in July that the ECB will do “whatever it takes” to safeguard the currency union. The pound has slid 7 percent in the same period.

Currency appreciation may dent growth by making goods and services of a country more expensive abroad and cut price pressure by lowering the cost of imports.

Losing Proposition

For investors who want to own euro-region inflation securities and profit from the euro’s gain, Germany is a better bet because of its top credit rating and stronger economy, said Robin Marshall, director of fixed income at Smith and Williamson Investment Management in London, which oversees $19 billion.

“We look to benefit from further gains in the euro, but we’d rather buy German index-linked bonds than French bonds,” he said.

French index-linked bonds have lost investors 1.8 percent this year through yesterday while their German peers fell 1.1 percent, according to Bank of America Merrill Lynch indices. U.K. inflation bonds handed investors a 2.3 percent gain while Italian securities rose 1.3 percent.

The inflation rate in the euro zone will fall to 1.9 percent this year from 2.5 percent in 2012, according to the median of analyst forecasts compiled by Bloomberg. The consumer-price growth rate will be 1.7 percent in France, 1.9 percent in Germany, and 2.6 percent in the U.K., separate surveys showed.

Weak Spot

France is a benchmark for euro-denominated inflation-linked bonds because its market size -- at 173 billion euros ($229 billion) -- is more than triple the 55 billion-euro German linker market. France started selling the securities in 1998 while Germany didn’t issue its first such debt until March 2006.

French inflation bonds posted a 15 percent return last year even as the euro-region was in recession.

The demand was driven partly after a rating downgrade for Italy in July kicked the southern European country’s index-linked bonds out of key benchmarks including Barclays Plc’s World Government Inflation-Linked Bond and Euro Government Inflation-linked Bond indexes.

While policy measures by the ECB and European leaders have reduced the risk the monetary union will splinter, the 17-nation group remains the world economy’s weak spot after the sovereign-debt crisis that started in Greece in 2009 tipped it into recession. The euro area’s economy will contract 0.3 percent this year, according to the mid-point of the ECB’s forecast.

Continuing Rally

France’s 10-year break-even rate, a market gauge of inflation expectations derived from the difference in yields for index-linked and regular bonds, rose at a slower pace than its peers. The rate increased 12 percent from a year ago to 2 percentage points earlier this week.

The German break-even rate of the same maturity climbed 16 percent to 1.87 percentage points while the rate in the U.K. rose 20 percent from a year ago to 3.24 percentage points.

“French linkers are expensive given their current spreads to German bonds, and they also offer little protection if the euro zone blows up again,” said Smith and Williamson’s Marshall.

For now, there’s little indication the euro’s rally will end anytime soon. Draghi told reporters on Feb. 7 that the euro’s appreciation is a sign that confidence has returned to the currency. While the exchange rate isn’t a policy target, he warned it is “important for growth and price stability.”

Reversing Bets

Hedge funds and other large speculators have reversed bets on the common currency this year, after their net wagers on the euro’s slide reached on record in June.

The difference in the number of bets these investors have on rise in the euro versus the dollar and those for a fall, so-called net longs, reached 37,952 this month, according to the Washington-based Commodity Futures Trading Commission data.

“Our currency strategists expect to see an overshoot in the euro appreciation in the near-term,” said Morgan Stanley’s Heese. “Currency moves can have a substantial impact on inflation markets over the longer term. With hindsight, the depreciation of sterling in late 2008 contributed significantly to the sustained and surprisingly high increase in the U.K. inflation between 2009 and 2001.”

The euro weakened 0.2 percent against the pound to 86.28 pence as of 2:45 a.m. in London. Still, the single currency is set for a second weekly gain against sterling.

French Economy

Meanwhile, France’s shrinking standing in the region, with an economy that’s teetering on the brink of recession and joblessness at a 15-year high, is playing out in its nominal bond market as well.

French debt is underperforming securities from other core nations in Europe, except the Netherlands, in February.

The French economy dipped into recession last year and shrank more in the fourth quarter than in any other since 2009 as manufacturers slashed tens of thousands of jobs and President Francois Hollande squeezed the budget deficit.

“France and Italy are two euro-zone countries we are wary of in terms of getting sustainable growth back into their economies,” said Paul Mueller, a money manager at Invesco Asset Management in the U.K., which manages $713 billion. “I can see a tactical opportunity to go underweight French index-linked versus German linkers.”

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