European bond markets are being driven by French elections and ECB policy directions

The main driver of European bond markets this week (as during the two or three previous weeks) has been political develop-ments in France in the run-up to the presidential elections (with François Bayrou joining up with Emmanuel Macron, the environ-mental party candidate doing the same with Benoit Hamon, and polls pointing to a very low voter turnout). The prospect of a victory by Marine Le Pen, which would open the door to a possible French exit from the euro zone, continued to squeeze French bonds.

The France-Germany spread is at a high since the end of 2012 (at 74bp on Friday). Keep in mind, however, that the credit risk premiums on almost all euro zone countries has risen in recent weeks, given that the euro zone’s fate requires France’s participation. Meanwhile, the retreat to German bonds, deemed safer, sent the 10-year German yield down to 0.20%, a year-to-date low.

In light of the above, it’s better to stay conservative until the elections but while keeping in mind that the ECB had said that its monthly asset purchases would move back to €80bn “If … the outlook becomes less favourable or if finan-cial conditions become inconsistent with further progress towards a sustained adjustment of the path of inflation”.

For the moment, IG and HY euro bond spreads seem to be ignoring the political risk from French elections. Despite the widening in the France-Germany spread, IG and HY euro spreads have remained stable. IG debt of companies domiciled in France exceeds €400bn, or 23% of the index, making France the country with the heaviest weighting. What’s going on here?

• One possible answer is that yields on certain bonds is lower than government bonds, for example when their issuers generate most of their revenues outside their home markets.
• QE has been instrumental in shrinking the corporate bond risk premium. The ECB’s CSPP remains a strong source of support for euro credit markets in buying up €59bn in bonds thus far, or an average of €1.7bn each week. If this pace held up, the ECB would hold €130bn in corporate bonds by year end, or 17% of the current eligible universe. 

The French elections will also be a decisive event for the euro credit markets over the coming weeks. Spreads on euro-denominated bonds could widen in the event of:

• Heightened political risk. A significant increase in Marine Le Pen’s chances of victory would inevitably raise credit risk pre-miums. Remember that during the euro zone sovereign debt crisis of 2011-2012, sovereign stress ended up contaminating corporate bonds.
• A slowdown in ECB purchases. Monthly purchases will fall from €80bn to €60bn in April 2017. €60bn is still a lot, but inves-tors could take a dim view of the prospect of a premature end to the ECB’s programmes. Jens Weidmann did, after all, say this week that the idea of an ECB rate hike in 2019 was not absurd.

Clearly, euro bond markets will continue to be driven by political risk and the direction of ECB policies.