(Bloomberg) -- France’s status as one of the safest bond markets in Europe risks coming to an end as a fragile minority government struggles to address a debt problem years in the making.
For the first time since at least the global financial crisis, France’s benchmark bond yield is higher than that of Spain and Portugal. The rate is also the closest it’s been in over a decade to that of Italy and Greece.
The deterioration of France’s credit risk is upending the traditional hierarchy of the euro-area sovereign debt market, which typically saw its two largest economies — the first being Germany — as the safest borrowers. Now, investors are demanding more to lend money to France than to some of the nations once at the heart of the region’s debt crisis.
“I cannot follow the argument that France is still part of the ‘core’ — it is clearly not,” said Moritz Kraemer, chief economist at German bank LBBW and a former senior ratings analyst at S&P Global Ratings. “Not in the eyes of the markets, not in the eyes of the rating agencies, and not in my eyes either.”
More broadly, the mounting skepticism toward French debt reflects how the world has changed over the past couple of years — with interest rates no longer at zero, investors have plenty of bonds to choose from that offer tantalizing returns from issuers with improving finances. That’s allowing them ratchet up the pressure on the most profligate spenders.
Kraemer considers France to be in a “hybrid position,” but says the trend points to it joining the peripheral markets, given the disarray in its finances and its political instability. The additional spread that Italian bonds offer over France has collapsed below 50 basis points, the lowest since 2010.
With France failing to meet its long-term fiscal goals, the new government faces the politically unpalatable task of cobbling together a budget that includes deep spending cuts and higher taxes in a bid to bring the deficit back under control. The proposal has to be presented to parliament in the coming weeks.
The fiscal shortfall swelled to 5.5% of gross domestic product last year and government officials said Wednesday it may exceed 6% this year. That’s far from the European Union’s target of reducing it to 3% by 2027. Signs of a cooling economy — with the services sector contracting and inflation sinking — add to the challenge.
Paul Danis, the head of asset allocation at RBC Brewin Dolphin, said France’s fiscal situation is dire enough to ignite action from so-called bond vigilantes — a term coined in the 1980s to describe investors who sold Treasuries to push back against the US government’s largesse.
“They have to do something to address risks in France,” said Danis. “Looking at the size of France’s deficit problem when the economy is not that far off from full potential, I wouldn’t want to minimize the risk of spreads widening again.”
Political Deadlock
President Emmanuel Macron’s decision to call snap elections in June created a political deadlock that finally resulted this month in a new minority coalition. Prime Minister Michel Barnier will present his policy agenda to parliament on Oct. 1, which will be the first opportunity for opponents to call for a no-confidence vote.
As anxiety grows, the extra yield investors demand to hold France’s debt over safer German notes — a widely followed gauge of French credit risk — returned to levels seen in June, above 80 basis points. Guy Miller, Zurich Insurance Co.’s chief market strategist, said it could climb to 100 basis points, the highest since 2012.
“That’s not just possible, I think it’s probable. I can see that being the case into year end,” said Miller. “It would be a function of the political situation.”
To be sure, France’s dominant position in benchmark bond indexes may limit the extent to which some investors can sell its bonds. The nation makes up the biggest portion of Bloomberg’s euro government index at 24%, some 10 percentage points more than Spain.
France still retains a higher rating — AA level or equivalent by all three major firms — despite a downgrade in May. Spain, by contrast, is rated Baa1 at Moody’s Ratings, five steps below.
“France enjoys a conferred core status due to what we would argue are political considerations,” said Richard McGuire, head of rates strategy at Rabobank. But “there is already evidence this conferred core status is, at the very least, weaker than it was.”
McGuire says France’s deterioration could ignite a correction in peripheral bonds, which have outperformed in recent years as their governments took steps to plug deficits and bring large debt piles down.
While the European Commission projects that debt as a percentage of gross domestic product will drop in Portugal and Spain by 2025, France’s debt load is forecast to climb from 111% to about 114%.
“The recent action is certainly challenging the status quo,” said Evelyne Gomez-Liechti, a multi-asset strategist at Mizuho International. “This move puts a bit into question the whole core versus periphery hierarchy thinking.”
Italy and Greece still have higher debt ratios, but they’ve been making strides in increasing investments and boosting growth. Greece is a case in point: its 10-year bonds pay a premium of just over 90 basis points over Germany, compared to 150 basis points this time last year.
The Italian yield spread over Germany, meanwhile, has been stable at about 135 basis points for months and earlier this year reached the tightest since 2022. That’s a sign investors remain confident that premier Giorgia Meloni will continue to appease Brussels by working to improve the government’s finances.
“If France is unable to address structural issues, it will join Italy in the euro-zone periphery,” said Mark Dowding, chief investment officer of RBC BlueBay Asset Management. “The direction of travel may see risk-averse investors seek to allocate away from French bonds in the weeks and months to come.”
--With assistance from Naomi Tajitsu and Sujata Rao.
(Updates with economic figures in eighth paragraph.)
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