C’est l’économie… French and German bond yields diverge

The recent divergence between French and German government bond yields has been widely attributed to a possible victory for the anti-euro Marine Le Pen in the French presidential election. In our view this is not the whole story. The widening gap in terms of borrowing costs also mirrors the increasing economic divergence between France and Germany. Therefore, the increased risk premium for French government debt should be expected to persist, even after the election of a mainstream candidate, adding to pressure on the euro project.

In recent months, the difference between the yield on French and German government debt has widened notably, Exhibit 1. After many years of being perceived as an anchor state within the eurozone, France is now at risk of joining Italy on the new periphery with a familiar but challenging combination of high indebtedness and slow economic growth.

Exhibit 1: Sharp increase in yield premium on French 10y bonds v Germany

We believe this increase in the French cost of credit should be carefully attributed. Some commentators have leapt on a significant increase in redenomination risk to explain the divergence, due to the upcoming French presidential election and the strong support for the anti-euro Marine Le Pen. This is despite still relatively long odds of her becoming French president, due to the two-round election process in France. We also note that the yield on Dutch government bonds has stayed close to German bunds, despite an upcoming election with polls showing the anti-euro and right-wing PVV party in the lead.

Exhibit 2: Divergence within the core – French indebtedness decouples from Germany

Polls currently suggest that Marine Le Pen will enter the second round of the French presidential election as the candidate with the highest level of popular support. However, she is then forecast to be soundly beaten as support coalesces around the one remaining centrist candidate in the second round.

A much more mundane reason for differing yields between government bonds issued in the same currency is credit risk. Since the downgrade of 2013, France’s S&P credit rating of AA is clearly inferior to the AAA rating of Germany. Government debt to GDP in France is just under 100%, growing and well above Germany’s figure of 70% which has been falling in recent years. The gap is forecast to widen further as France continues to run deficits while Germany maintains a surplus. As Exhibit 2 shows, the period since 2012 represents a structural break from the period 1996-2011, when French and German indebtedness fluctuated in tandem, in-line with the economic cycle.

We also note that market yields on bonds issued by French state-owned companies which are similar except for the choice of governing law do not at present indicate a rising fear of redenomination. Unlike bonds issued under French law, where parliament may be able to change legislation to permit repayment in another currency, international law bonds would be likely to remain repayable in euros, even if France left the eurozone. The lack of divergence in the price performance of these similar bonds in recent weeks is another reason to suspect that the move in French government bonds is re-pricing based on credit quality, rather than politics. Furthermore, recent projections from the EU commission which show France missing the euro area budget deficit target of 3% in 2018 are hardly beneficial for confidence.

Having suggested that rising French borrowing costs are due to deteriorating credit quality rather than redenomination risk does not however make us breathe easier. If it were redenomination risk that the markets were pricing in, then after the election of a centrist candidate the panic would be over.

However if we are correct and the market is pricing credit risk, the diverging economic fortunes of France and Germany may lead to a permaneent divergence in borrowing costs. It would represent an unwelcome further fragmentation of eurozone funding markets, despite the efforts of the ECB to level the playing field through quantitative easing. It is also not immediately clear what the ECB could do further to improve the situation. Headline eurozone inflation is already close to target and the inflection point towards tighter monetary policy may have already passed, even if policy will remain accommodative for some time. We note the discussion within the ECB relating to “limited and temporary deviations” from the ECB’s capital key to minimise (German) bond purchases below the deposit rate, but this appears unlikely to result in significant narrowing of the spread.

In hindsight, the near-absence of a risk premium for French government debt prior to 2017 appears to be the real anomaly. Now the fear is that punished by higher real rates, but unable to benefit from a depreciating currency, France may have no clear mechanism for achieving fiscal or economic convergence with Germany. Therefore, through a circuitous route of diverging economic fortunes within the common currency area, thus feeding escalating borrowing cost differentials, the euro is not yet out of the woods, despite the best efforts of the ECB.