Are French government bonds still a sound investment?

Recent market volatility has not been limited to France. Other European government bond markets, as well as bonds issued by banks, including French banks, have also come under pressure. The turbulence that began in France can therefore spread. We should not underestimate this risk of contagion, particularly if political uncertainty increases further.

Despite these concerns, we do not expect another euro crisis. The current situation differs fundamentally from previous major crises. For now, investors are primarily pricing in greater political and fiscal risks, resulting in higher risk premiums on French government bonds. We do not see a fundamental loss of confidence in the eurozone. More on this can be found in recent publications by ABN AMRO Group Economics, including the report ‘ECB rescue for bond markets remains distant’.

In the short term, financial markets are primarily responding to France’s budget challenges, while also closely monitoring the possibility of further riots and demonstrations. A budget agreement could temporarily reassure the bond market, but would not resolve the underlying problem. The French government will need to put its finances on a more sustainable footing. However, substantial spending cuts and tax increases have little public support. Such measures could also weigh on French economic growth.

Towards the end of the year, financial markets will turn their attention to the French presidential elections. Political polarisation is high, and the future direction of policy remains uncertain. We therefore expect the risk premium on French government bonds to remain elevated for now, and cannot rule out a further increase as the elections approach.

For the markets, a victory by a moderate candidate would be the most favourable outcome. However, it is the more extreme candidates who are currently gaining in popularity. In particular, the policies advocated by far-left candidate Jean-Luc Mélenchon would run counter to what financial markets would prefer. Polls suggest that his chances of reaching the second round to face Marine Le Pen are edging higher. The likelihood of Mélenchon ultimately winning the election remains small, but cannot be ruled out entirely.

If turbulence in the French government bond market becomes too severe and spreads significantly to other countries, the European Central Bank (ECB) could intervene. The ECB has several tools to address severe turbulence in European bond markets. However, we believe it will be reluctant to deploy these tools at an early stage. Market pressure, in the form of higher yields on French government bonds, could help encourage the reforms that France needs. Intervention also becomes more politically sensitive when bond market movements are linked to the elections.

This means that risk premiums on French government bonds could rise further before the ECB intervenes. However, if the situation develops into a systemic risk for the eurozone, we expect the ECB and other European institutions to act eventually. A French default, debt restructuring, or exit from the euro is explicitly not our base case.

Risk premia on French government bonds have risen. Political uncertainty and market volatility surrounding France are likely to persist for now. However, we do not expect France to become unable to meet its financial obligations. If market turbulence becomes too severe, we expect the ECB to intervene. We therefore see no reason to conclude that French government bonds are not a prudent investment.

Willem Bouwman
Senior Fixed Income Portfolio Manager (ESG and Impact)