Forget Trump for a moment ...... It's French elections and bond spreads

Forget Trump for a moment ...... It's French elections and bond spreads

ref :- "Fillon "fake jobs" scandal shakes French bonds as Le Pen fears rise", The Financial Times

see also :- Editorial, and Capital Markets Analysis

Back from a break and it's always interesting to see what's been grabbing the attention whilst you've been away. Of course, no matter how far one travelled it would have been impossible to get away entirely from all matters Trump  --  trade wars, brawls with the Judiciary, possible waning enthusiasm for Trumpflation trades etc etc  --  and that's not going to change (not for at least four years, at any rate). But for the Financial Times at least, Issue of the Day is undoubtedly the upcoming French presidential election, and its effects on bond markets.

Note : 1st round April 23rd, two leading candidates progress to 2nd round May 7th.

Centre-right candidate Francois Fillon, who had been leading in most polls, has been engulfed by a scandal after it was revealed that he had put his wife and two kids on the government payroll to the tune of about 1 million euros. If, as some allege, the jobs were fake, then M. Fillon would face accusations of corruption. If they were genuine (the best-case scenarion for M. Fillon), then he's merely guilty of poor judgement. Either way, it's not good news at all for him  --  his candidacy may not even survive  --  and it's good news for National Front Leader Marine le Pen.

As the far-right representative, Ms Le Pen could naturally expect to pick up her fair share of any drop-off of support for the centre-right opposition. But probably more to the point, these latest revelations are the perfect example of the kind of nest-feathering by political elites at the expense of the working man that has caused voters across the western world to reject the political mainstream and to turn instead to alternative populist parties of both the left and the right.

So what does this added uncertainty do for financial markets ? Just like pollsters and political forecasters, markets were wrong-footed by crucial events in 2016 (Brexit, Trump etc) and have consistently underpriced the political risks. One could argue that the sharp reaction in bonds markets signals a determination not to let this happen again. That would only be sensible, given the National Front's commitment to withdrawing from the Euro and to hold a referendum on membership of the European Union itself.

Trading bond spreads, in this instance the difference in bond yields between one nation's government debt and another's, is perhaps the neatest way to hedge political risk. Taking Germany as the most solid Eurozone member economically and therefore German Bunds as the benchmark for government debt, the spread between the 10yr Bund and its French equivalent is much in focus. Yesterday, the spread traded at 78 basis points (France over Germany), a reflection of the yield premium investors currently require to buy French debt rather than that of its German neighbour. For the yield spread to be trading at that differential between the Eurozone's two largest members is a big deal.

To put it in perspective, it's the largest differential between the two since November 2012. In early 2015, the spread was trading below 20 bp, and approached 20bp again as recently mid-2016.

There are alternative views on the move, of course. One might argue that the widening of the spread is a function of speculation that the ECB will soon start to taper its bond-purchasing programme now that there signs of growth and inflation returning to the Eurozone as a whole. By buying government bonds across the Eurozone, the ECB has artificially suppressed yield spreads and any reduction in the programme would no doubt see differentials widen to more "normal" levels. Some might also make the case that the sharper rise in French yields compared to German ones reflects the possibility of France making up some lost ground economically after the election. Then there are those that say current French yields are similar to those in Ireland for example and therefore plainly too high.

Of those three arguments, the first would seem to hold some water. The second is highly debatable, and to the third you could well point out that it's not French yields that should be lower but Irish ones that should be higher, given Ireland's crucial trading links with a UK about to leave Union and all the problems that will pose for Dublin. Whatever the case, the biggest part of this move can be put down to political risk and that seems entirely logical.

So how is the election shaping up with the bookies ? Ms Le Pen is widely expected to make it through to the May 7th run-off, where she is expected to be defeated by whoever else gets through as the mainstream parties collude to keep the Nationalists from power. The problem is that the identity of that other finalist keeps changing. With former favourite Fillon relegated to third in the betting, new leader at the top of the odds board is independent Emmanuel Macron, while the Socialists are trumpeting a rise in support for Benoit Hamon.

It's too tough to call at this stage, which is exactly why bond traders are taking cover in the spreads.