French risk France's Bond Scare

Despite today’s stock market highs, political uncertainty in Europe, especially over the elections in France, is making investors take shelter in bonds. It’s a wise strategy, writes Andrea Cünnen.
Marine Le Pen is currently topping first-round polls in France.

It’s a paradox. The latest economic data signal an economic upturn in the euro zone, and stock markets are also aiming for new highs. At the same time, however, investors are retreating into safe German government bonds. This has led to a decline in the yield on 10-year German government bonds to 0.25 percent, while two-year bonds have reached a historic low, yielding minus 0.92 percent.

The euro is also unable to benefit from the clear signs of economic growth in stock markets, approaching its annual low as the currency trades at just under $1.05.

While equity investors are successfully ignoring all risks, the bond and foreign currency markets are sending alarming signals. This is completely justified, given the enormous political risks for the euro zone this year, especially with regard to the French presidential election.

Far-right candidate Marine Le Pen's prospects of winning the decisive run-off election on May 7 are seen as slim. But the leader of the Front National, who explicitly wants to get rid of the euro and reintroduce the franc in France, is catching up in the polls.

It would be the biggest default in history, in light of France's outstanding government debt of €2.1 trillion.

This is especially evident in the bond markets. The more Ms. Le Pen catches up, the sharper the increase in France's risk premiums, or the differences in yield between French and German government bonds. Since the beginning of the year, the risk premium on the two-year French government bond has swiftly increased to 0.4 percent, while that of the 10-year bond has gone up to 0.8 percent.

The last time these barometers of fear were this high was more than four-and-a-half years ago, although they are still only half as high as in the summer of 2012. That was when Mario Draghi, president of the European Central Bank, protected the euro zone from collapse with his magic words, saying that the ECB would do everything to save the euro zone from falling apart.

Nevertheless, risk premiums have risen sharply since the beginning of the year. Such a rapid increase shows that investors are extremely concerned. For this reason, efforts to appease investors by saying that the markets are simply differentiating a little more between the economic strength of individual countries are inappropriate.

This is also evident from the fact that there has been a considerable increase in revenues in French government bonds recently. It is also reflected in the questions investors are asking. Suddenly they are interested in knowing what the legal bond terms look like and whether France could simply decide to repay its bonds in francs instead of euros. They are asking which courts would have jurisdiction over potential lawsuits. And they want to know how the powerful rating agencies, Standard & Poor's, Moody's and Fitch, would react to France returning to the franc.

The mere fact that investors have to think about these questions is dramatic enough. In the end, it also calls into question the future of the German-French relationship, the most stable axis in the European Union. This is alarming to anyone who is not one of those diehards who believe that in today's interconnected world, with the United States, Europe and China as large economic blocs, small nations with their own currencies are better off than a strong European community.

What exactly would a French departure from the euro mean? Not even Marine Le Pen can answer that question. For instance, she claims that investors don't care which currency France uses to repay its debts. But that isn’t true.

Theoretically, a government, with the approval of its parliament, can leave the European Union and therefore the euro. But the new currency would be dramatically depreciated. Investors would lose money, turn away from France and try to sue for their right to full repayment. The rating agencies would treat France's refusal to repay the bonds as agreed upon as a payment default.

In fact, it would be the biggest default in history, in light of France's outstanding government debt of €2.1 trillion. Investors, fearing the collapse of the euro zone, would immediately retreat from the bonds of southern European countries. Refinancing costs for these countries would shoot up so dramatically that the next bankruptcies would be practically guaranteed. Even the ECB would be unlikely to come to their aid, especially as a communitization of debt would encounter massive resistance in Germany and other, smaller euro countries.

A French President Le Pen is not the main scenario for bond investors. But they are giving serious though to the "what if?" question. Euro opponents in Germany and other countries, as well as investors in equity markets, should follow their example. If Europe breaks apart, all stock market forecasts, as optimistic as they are today, would become obsolete.


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