The political turmoil in France briefly eases in the bond market but cannot hide economic concerns

According to Zhitong Finance APP, the French bond market seems to have temporarily gained some breathing room, but the aftershocks of the political crisis will hurt businesses, consumers, and taxpayers.

The Barnier government is expected to collapse as early as Wednesday, with the far-right National Rally led by Marine Le Pen planning to overthrow the government. Previously, Barnier's €60 billion (USD 63 billion) austerity budget sparked controversy, aimed at keeping the budget deficit within twice the EU limit.

The political crisis has triggered severe market volatility. On Monday, French government bond yields briefly surpassed those of Greece, which had previously received a bailout.

Last week, the risk premium (i.e., yield spread) between French and German government bonds rose to 90 basis points, the highest level since 2012, reminiscent of the EU debt crisis.

All of this has reignited discussions about the return of the "bond vigilantes." "Bond vigilantes" refer to investors who successfully force governments and central banks to change policies by driving down bond prices and raising bond yields.

However, large investors believe that the latest turmoil is merely the next act in a long reckoning, rather than a market crash like the one experienced by the UK in 2022.

Market Gains Temporary Breathing Room

Christian Kopf, head of fixed income and foreign exchange at Union Investment, stated, "This is a slow-burning crisis that will lead to a sustained widening of spreads and continued deterioration of sovereign credit."

Kopf added, "But for now, I don't think the situation will completely spiral out of control and evolve into a full-blown sovereign debt crisis." Kopf has given French government bonds a "reduce" rating.

If the Barnier government collapses, it would mean the end of its austerity plans, and investors expect spreads to rise to around 100 basis points, indicating that the French market will suffer more pain first. This would also mean that investors' assessments of France are increasingly approaching those of Italy.

The spread between French and German government bonds has risen to the highest level since 2012.

Without Barnier's measures, the French Treasury estimates that next year's budget deficit could reach 7% of economic output, rather than the target of 5%.

Despite increased uncertainty over the past two weeks, France's borrowing costs have decreased, driven by expectations of interest rate cuts from the European Central Bank.

Since French President Macron announced early elections in June, the yield on 10-year French government bonds has fallen by more than 20 basis points.

Chris Jeffery, head of macro strategy at Legal & General Investment Management, stated, "There is no snowball effect of rising yields triggering greater concerns about debt sustainability." He maintains a bullish stance on French bonds, as much of the bad news has already been reflected in prices The rating agency Standard & Poor's maintained France's AA- rating on Friday.

Officials told the media that France's European partners also believe the likelihood of escalating tensions is limited.

Over the past two weeks, Italy's risk premium has remained stable, while France's risk premium has increased—this is a far cry from ten years ago when market anxiety spread among high-debt countries in the Eurozone.

Additionally, although the European Central Bank has boosted confidence in the bond market by purchasing government bonds from specific countries through the Transmission Protection Instrument (TPI), external observers expect the ECB will not intervene anytime soon.

Greek Central Bank Governor Yannis Stournaras stated on Monday that "the country needs to take all necessary measures to address the deficit issue," temporarily ruling out the possibility of intervention.

"Tough days" still ahead?

Even if the market currently appears to be under control, the collapse of the Barnier government would reduce France's chances of addressing urgent fiscal issues.

Mark Dowding, Chief Investment Officer at BlueBay Asset Management, stated: "French society is unwilling to accept cuts to social welfare and an extension of the retirement age. For this reason, changing the trend seems difficult."

Political uncertainty has also left businesses in a tightening state amid unclear tax and broader economic policies.

This could put pressure on tax revenues, with unexpectedly weak tax income being one of the main reasons for France's deficit exceeding expectations this year.

Leo Barincou, a senior economist at the Oxford Economics Institute, stated: "The main channel of impact is through corporate investment and hiring."

Business surveys show that hiring intentions have fallen to their lowest level since 2021, and a weak labor market could harm consumer spending, whereas economists had previously expected consumer spending to benefit from increased purchasing power due to declining inflation.

However, this political crisis means that consumers—traditionally the driving force of French economic growth—are now likely to continue saving any extra income.

Even before this week's crisis, consumer confidence was at its lowest level since Macron announced the election.

French banks, which are an important source of financing for businesses, have also been hard hit. Since Macron announced the election, the stock prices of Société Générale, Crédit Agricole, and BNP Paribas have fallen by 7%-15%.

In the context of a weak European economy and the potential for new tariff policies from the United States, political instability makes France particularly vulnerable.

Sylvain Bersinger, an economist at the French economic consulting firm Asteres, stated: "We need a clear-headed and stable government, but we face the risk of having no government."