France's Bond Sell-Off
Part I: What's this going to cost you?
All sorts of French - from earnest students to masked casseurs (hooligans) - are running amok in the streets. It’s something of a national pastime, not the reason for the vivid sell-off in French bonds. Still, it may be one of those things that comes back to bite the debt crisis in le derrière.
France’s 10 year debt is around 5% – about 180 basis points over comparable German Bund. This is partly a technical unwinding of investors pushing into French debt this summer when the pal offered attractive yields and diminishing risk. It assumed falling energy prices would improve the economy, ease cost-of-living distress and distract the citizenry from trying to burn the place down.
Overlooked at the time was that neither Washington nor Tehran clearly understand what the Memorandum of Understanding actually said. So it lasted about as long as a wicked hangover. Recent leaks out of both Washington and Tel Aviv suggest fresh strikes on Iran are being planned for after elections. Switching prime ministers won’t change much - Gadi Eisenkot is no dove, and he’s not about to push back on the White House and get himself Zelenskyed. Meanwhile, Houthi pressure is keeping apace - on Oct 27 they attacked Ras Tanura, Saudi Arabia’s largest oil refinery. All of which will keep energy costs high, along with price of everything else. It’s also going to keep France - fussy on a good day - and the rest of Europe in riot gear.
So, having guessed wrong, investors are unwinding the overhang. These shocks have a nasty habit of exposing the problematic signal beneath: Like how a fender bender won’t kill your marriage - unless your mistress is in the passenger seat.
Apples and L’ Oranges
Understand that a 5% yield on ten year debt isn’t a default threshold - US Treasuries are just under 5% and the UK gilt is yielding 5..3%. Washington’s debt load isn’t far behind that of Paris, and we’re doing our best to catch up. But absolute metrics aren’t much use: Unlike the weirdly resilient US dynamo, the French economy is stuck in a low growth stupor that is heavily taxed. Paris has very little room to maneuver on its debt. The current left-wing favorite Jean-Luc Mélenchan is calling for an effective government default, but no one really thinks its going to happen. He’s a distant second to the far-right favorite, Marine Le Pen, who is calling to lower the retirement age, which will hockey stick the already massive state pension costs.
This isn’t a new state of affairs - Paris hasn’t balanced a budget sine 1974. Ten years ago Emmanuelle Macron came to office as a radical centrist to get the country’s moribund economy and its finances in order - at least by French standards. But there is a very good reason that the French protest so much - it works: In 2018 Macron’s answer to the gilets jaunes cost of living protests was to throw billions in concessions to settle the unrest. Two years later waves of Covid 19 spending were as enthusiastic as they were scattered. Now debt is overwhelming, financing is in tatters and protests are demanding more money for education which the Paris can’t afford, along with tamping down cost-of-living and oil prices, over which it has no control.
Can France produce a credible fiscal plan that survives worked up political opposition? Probably not. The wider problem is that while France looks ungovernable, it’s also starting to resemble like a canary in a coal mine: similar protests are happening in Belgium, Spain Portugal and Italy, causing the political center to collapse as voters break hard left or right.
L’Orange and a Hard Place
All of which puts the European Central Bank (EBC) in a bind. True, it’s in better shape to deal with fiscal crisis than it was in the 2011-12 Euro crisis, but there is only so far that toolbox can scale. It’s one thing to bail-out Greece, but France is one of the two economic anchors on which the EU is built. The ECB very well may try to cap yields in Spain and Italy, but it won’t do any good if Paris goes pear-shaped. The resulting the contagion could easily spread through the Eurozone, and that might blow the EU up. Germany’s AfD may catch hell for being anti-immigrant but it started life as an anti-bail-out party. The AfD even opposed removing the German debt brake to rearm before a Russia.
Currently, the markets are betting that France, as it does, will muddle through throwing money at protestors and raising debt costs across the Eurozone. My guess is that that is the smart bet with the caveat that the world doesn’t always reward the smart bet. French debt is expensive, but the market is still functioning. Anything that large is fundamentally stable. Fundamentally, yes, but not absolutely.
The Field Guide: So why do you care?
First, the good news: A Eurozone debt crisis is likely to trigger a flight to safety that pushes down US Treasuries. This will strengthen the dollar, although whether or not that’s a positive depends on how you make your money. Still, large deficits are limiting room to maneuver on either side of the Atlantic. So don’t assume the rally will last.
Second, the annoying new reality: Geopolitical risk is now a direct input into your financing costs. The trick isn’t to predict the future but to hedge your bets by establishing your exposure when financing becomes more expensive.
Third, the tea leaves: Watch the long end of that yield curve, that will provide some shape on where inflation and future financing costs are headed. Tea-leaves are not a crystal ball, however. The fairly predictable global world order is over. Your best bet is to keep an eye on the connections, model scenarios and get as comfortable with the idea that when financing conditions are uncertain, it pays to flexible.
