When France’s weak economy and public finances are panned by international critics, its politicians have an easy riposte: just look at our bond yields.
Paris can borrow at lower costs than London, and the spread between French and German 10-year bonds has remained remarkably stable over the past year.
Standard & Poor’s early morning announcement two weeks ago of another downgrade – this time to double A – failed to cause markets to choke on their croissants. Investing in French assets cannot be so awful.
Could that change as the US Federal Reserve starts to wind back its exceptional stimulus measures? Among investors I have spoken to recently, a school of thought is developing that it might.
During the global “taper turmoil” earlier this year – the weeks after May 22nd when Fed chairman Ben Bernanke first hinted at his plans to taper or scale back Fed asset purchases – euro zone bond markets remained surprisingly tranquil, even as emerging markets sold off sharply.
But while global policy-makers and economists still struggle to understand the interlinkages between Fed actions and global markets, it seems implausible that Europe can escape unscathed when tapering becomes real, perhaps as early as December.
After all “global QE” – quantitative easing by the Bank of Japan as well as the Fed – drove European bond prices higher and yields lower; taper turmoil showed the potential for disruption when it goes into reverse.
Stabilising factors
If there will be European fallout, where will the effects be worst?
Intuitively the weaker euro zone “periphery” economies seem most at risk of a market correction as global QE ebbs, especially if fresh taper turmoil increases investors’ risk aversion.
In fact, countries such as Spain, Italy and Ireland have benefited from four stabilising factors this year.
First has been their transition – thanks to the European Central Bank acting as a backstop – from existential crises to something nearer normal economic conditions. Growth is low and unemployment alarmingly high, but the danger of imminent ejection from the euro has gone.
Second, at least Irish and Spanish bonds have benefited as turnround stories, with tangible evidence of structural reforms improving competitiveness and growth prospects.
Third has been the “re-domestication” of Spanish and Italian bond markets – fickle foreign investors have fled.
Fourth, euro zone periphery countries have moved decisively from current account deficits to surpluses; they no longer rely on capital from overseas.
All four supporting factors will remain in place even as the Fed tapers. None, however, apply to France. Instead other reasons explain the impressive performance of France’s bond market this year – and why it might now be vulnerable.
Higher bond yields
When the Fed was ramping up its asset purchases and US treasury yields were falling, global investors looking for higher returns were attracted by France's large and liquid bond markets. Until June this year, French 10-year yields were higher than US equivalents.
France was considered part of the euro zone’s safe northern core which made it attractive to investors for whom German Bund yields were simply too low. The Swiss central bank was an avid buyer of French bonds, as were Japanese banks.
The case against France is that if the Fed slows its asset purchases and US treasury yields rise, those inflows could start to reverse and French bonds would sell off – perhaps sharply.
Eric Chaney, chief economist at Axa, points out the very different debt profile between France and Germany. As a share of GDP, French public sector debt will soon be 20 percentage points higher than Germany’s. Without action to alter France’s debt dynamics, the spread between French and German bonds could widen by 50 or 100 basis points, warns Chaney.
French politicians probably need not worry just yet. Investors shorting French bonds have often lost their berets.
When French yields have hit instability in the past it has been because of obvious systemic risks – the exposure of its banks to the euro zone “periphery” economies in 2011, for example. Whatever the risks posed by Fed tapering, it is hard right now to see what might trigger another big sell-off. As the euro zone crisis has lost intensity, euro zone bonds have performed more like “rates” markets, with yields linked to growth and inflation prospects, rather than default risks. France’s economy is contracting, which will curb any uptick in yields.
Still, as Fed tapering draws near, markets may make life less comfortable for French politicians – and limit their bond yield-bragging possibilities. – The Financial Times Limited
