Photographer: Krisztian Bocsi/Bloomberg

European Bonds, Not the Euro, Take the Biggest Political Hit

  • Currency moves of 2016 prove no benchmark but bonds suffer
  • Improving economic data can’t eclipse looming political threat

Political risk battered a host of currencies last year, but in Europe in 2017 it’s bonds that are bearing the brunt. 

The yield difference between 10-year bonds from France and Germany widened on Monday as investors priced in growing concern the anti-euro Marine Le Pen could win the French presidential election. In Italy -- reeling from a near crisis in its banking industry and bracing for its own potential elections -- a similar spread hit the widest in more than two years. Meanwhile, the euro has gained 1.9 percent this year, even allowing for a slump on Monday.

“The differing bond performance reflects a long overdue re-assessment of political credit risk premia within the euro zone,” said Marc Ostwald, a strategist at ADM Investor Services International Ltd. in London. “On the foreign exchange side, it’s rather more difficult as Germany is very much part of the euro, as are a number of other ‘stable’ countries,” not to mention the euro zone’s current-account surplus, he said.

Improving Data

Contrast the moves with risk events last year, in countries such as the U.K. The British pound slid to its weakest level in more than three decades, and benchmark gilts rallied after the nation voted to leave the European Union.

The euro’s resilience and rising regional yields are underpinned by growing speculation that the European Central Bank may be nearing the end of its bond purchases. That view is supported by improving data across the bloc, which has shown accelerating inflation and growth, as well as the highest consumer confidence in six years. German factory orders rose the most in two and a half years in December, according to a report on Monday.

Le Pen’s Plan

Those stronger economic numbers have done little to sway investors, however, who are preoccupied by elections in the Netherlands, France, Germany and potentially Italy amid an increase in support for anti-euro rhetoric. While the currency has gained this year, it still lags all but two of the G-10 currencies, and will likely endure a selloff if political backing for it starts to disintegrate.

Le Pen, the National Front candidate, has set out a 144-point program for government that includes pulling France, the bloc’s second-biggest economy, out of the euro. The currency could fall 10 percent to about 98 U.S. cents over a few weeks if she wins, JPMorgan Chase & Co. strategists wrote in a note to clients on Monday.

That would be greater than the 6 percent drop experienced after the 2012 Greek elections.

  • The spread between 10-year bond yields in France and Germany has widened to almost 73 basis points from 48 basis points at the start of the year; the differential between Italy and Germany has widened 37 basis points to 198 basis points.
  • EUR/USD has advanced 1.9 percent this year; it pared gains on Monday, falling 0.6 percent to 1.0719 against the dollar as of 3:16 p.m. in London.
  • EUR/JPY weakened 0.7 percent to 120.55.
  • There have been a few relatively large calendar spread trades executed in bund options, selling upside dated in May and owning that in June, aiming to play the dates around the French election schedule, according to two traders in London who asked not to be identified because they are not authorized to speak publicly.
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