David McNamara: France faces its Waterloo on bond markets
French fiscal policy has become completely unanchored since president Macron lost his majority in the French parliament a few years ago.
European bond markets have continued to be roiled by ongoing political uncertainty in recent days, driving a steepening in yield curves, widening spreads for troubled sovereigns, and a depreciation in the euro.
Given the relatively muted trends in headline inflation versus the previous shock in 2022, current market pricing for central bank rates has fallen a little in recent weeks. Nevertheless, inflation worries have driven both the front end and long end of the curve since the US-Iran war began.
However, underlying this inflationary catalyst, markets are also pricing in greater risk premia on governments with poor records of delivering deficit reduction. France, Italy and the UK continue to stand out, enduring significant increases in borrowing costs, while also seeing spreads widen to safe haven assets such as German bunds.
Indeed, political uncertainty in Europe is also now providing a further leg-up to yields. A snap election called in Spain and street protests in France seeking greater public spending, despite the challenging fiscal arithmetic, are adding to political angst which was already high following the recent regional German elections.
French bonds now consistently trade wider than their Italian counterparts, with the 10-year trading between 130-140 basis points (bps) above the German equivalent compared to around 100bps for Italy.
At face value, the widening looks overdone, with both France and Italy running similarly sized deficits of around 5% of GDP, with Italy far surpassing France on its overall debt metric of nearly 140% of GDP versus 118% for its Gallic neighbour.
However, the direction of travel matters for markets. French fiscal policy has become completely unanchored since president Macron lost his majority in parliament a few years ago, whereas the political picture in Italy appears more stable.
There is also a significant risk of a victory for the populist right in the French presidential election next year, which, with a firmly anti-EU outlook, might further weaken EU cohesion at a time of geopolitical uncertainty.
The widening in spreads also brings the focus back on the ECB’s role, risking a politicisation of the institution. In 2022, the ECB tweaked the rules around its Pandemic Emergency Purchase Programme to provide greater “flexibility” in how it reinvested the proceeds from the programme.
In practice, this allowed the ECB to intervene to underpin the Italian bond market. The central bank subsequently created the Transmission Protection Instrument, which is a reserve ‘bazooka’ that can, in the ECB’s words, “be activated to counter unwarranted, disorderly market dynamics that pose a serious threat to the transmission of monetary policy across the euro area”.
On paper, France would fail the criteria for use of the tool, given it requires compliance with the EU fiscal framework, but with its perception as “too big to fail”, there could be increasing pressure on the ECB to act if the situation deteriorates further in the coming weeks.
Looking further ahead, political instability may remain a driver of bond market volatility over the coming year. Alongside the French presidential vote, elections are due across Europe in 2027, including in Italy and Greece.
- David McNamara is chief economist at AIB
