Bond Update: Surprise Shift in French Election Fails to Rattle Markets for Good Reasons.

Summary:

• The French election results may not be as harmful as feared, as the victory of the French left-wing New Popular Front without an absolute majority could moderate spending, leading to balanced governance and boosting long-term economic growth and market stability.
• In the short term, the OAT-Bund spread is likely to fluctuate between 62 and 80 basis points until the policy direction becomes clearer. At that point, the spread is likely to stabilize below 50 basis points.
• In the medium term, with the new French government's policy agenda taking shape, investors might move from Bunds to OATs, increasing pressure on Europe's safe-haven assets.

The recent surprise victory of the French left-wing New Popular Front, emerging as the largest group in the National Assembly with 178 seats, has introduced a new wave of uncertainty in the French financial markets. Yet, the French bond and stock markets are performing surprisingly well, with the CAC 40 up 1.25% since the open and French sovereign bond yields remaining remarkably stable. The 10-year OATs have held steady at 3.21% since last Friday’s close, and the 2-year OATs have increased by only 2 basis points since then.

Markets are coming to the realization that the result of the French elections may not be as detrimental as initially feared. The absence of an absolute majority for the left-wing coalition can serve as a moderating influence on extreme spending measures, with President Macron’s centrist alliance likely curbing radical fiscal proposals. This environment has the potential for balanced governance, which could encourage social investment while being fiscally responsible, restoring investor confidence in the long haul. If reforms to boost consumer spending and investment are enacted without significantly escalating debt, the long-term growth prospects for the French economy could improve, supporting the stability of the French stock and bond markets.

Potential market concerns following the French election results.

1. Political Instability and Gridlock: The election outcome has resulted in a hung parliament, leading to a potential gridlock in political decision-making. Forming a functional government will likely require weeks of negotiations, adding to the uncertainty. This instability can deter investors, causing volatility in the bond markets.
2. Fiscal Policy Concerns: The left-wing coalition's platform includes ambitious spending plans, such as increasing public expenditure, raising the minimum wage, and reducing the retirement age. If implemented, these policies could exacerbate France’s budget deficit and debt levels, which are already concerning. The potential for fiscal profligacy is likely to pressure bond yields higher, as investors demand greater returns for the increased risk.
3. Market Reaction and Credit Risk: The yield spread between French and German bonds has widened slightly post-election, reflecting increased credit risk perceptions. While this spread has eased from its peak levels, ongoing uncertainty about the coalition's ability to govern effectively may keep the pressure on French yields keeping the OAT-Bund spread at high levels.

French election results is also providing reasons for optimism.

1. Moderate Spending Restraints: Despite the left-wing coalition's leading position, the lack of an absolute majority may act as a moderating force on extreme spending measures. President Macron’s centrist alliance, which came second, will play a crucial role in any coalition, likely curbing the most radical fiscal proposals.
2. Potential for Reform and Stability: While immediate uncertainty prevails, there is a silver lining in the potential for more balanced governance. A coalition government that combines centrist and left-wing elements could lead to pragmatic policies that blend fiscal responsibility with social investment. This balanced approach could restore investor confidence over time.
3. Long-term Growth Prospects: If the coalition manages to enact reforms that boost consumer spending and investment without significantly escalating debt, the long-term growth prospects for the French economy could improve. Enhanced economic growth would support the bond market by stabilizing fiscal metrics and improving overall creditworthiness.

Considerations about the OAT-Bund spread.

As Marine Le Pen’s National Rally party appeared poised to secure a majority in the French government, the spread between 10-year French and German sovereign bonds spiked to 81.9 basis points, the highest level since the summer of 2012, during the European sovereign crisis. However, last week, when it became evident that the National Rally party would not secure an absolute majority, the OAT-Bund spread dropped below 66 basis points, the level at which the OAT-Bund spread peaked during the 2020 COVID pandemic. As policy directions become clearer while a governing coalition gets formed, the OAT-Bund spread is likely to fluctuate between 62 and 80 basis points.

While we believe political risk is often overstated by markets, it is notable that European sovereigns have become more sensitive to negative news since the European sovereign crisis. OAT yields, in particular, have frequently spiked to levels well above those seen during the 2008 global financial crisis. Given the uncertain monetary policy path of central banks on both sides of the Atlantic, elevated volatility is likely to persist. However, if the political and fiscal environment stabilizes, the OAT-Bund spread is likely to normalize, potentially dropping below 50 basis points.