Bears Are Circling France - Eurozone Crisis Watch

Problems with the French economy (GDP, PMI and unemployment), rising debt ratios, and failed policies in place could soon spook the French government bond market (increase interest rates) and cause the next crisis in the Eurozone. There's also a risk that Fed tapering could reprice French debt and widen the French-German yield spread. The CAC40 Index (France's benchmark stock index) and French government bond futures have already been declining since the beginning of December. So maybe a negative catalyst is starting to get priced in.

CAC 40 Index
Source: TradingView.com

Euro OAT Medium-Term (Eurex Future)
Source: TradingView.com

France 10-Year Bond Yield
Source: Investing.com

But after S&P downgraded France's credit rating on November 8, 2013, a commenter mentioned on my blog that France's 5-year credit default swap spread, the cost to insure $10 million of French government bonds for five years, was still very low at 50.67 basis points. Since then, the French 5-year CDS spread increased 2.83 bps to 53.50 bps.

When looking at the 10-year French-German bond yield spread (bond risk premium in the Eurozone), a Bloomberg article mentioned on December 9, 2013 that the spread has narrowed significantly since November 2011. (Rewind: "10Y French-German Yield Spread Hits 20-Year High On Moody's Review" on 10/19/2011; "10-Year French-German Spread +11% at 1.83" on 11/15/2011.) According to CountryEconomy's chart below, the 10-year French-German spread hit a high of 189 bps on November 16, 2011, and today it is only at 48 basis points. Still, all of these narrow spreads could just mean that French sovereign debt risk is being mispriced.

Source: CountryEconomy.com

First, here are quotes from the recent S&P report (emphasis mine):

The downgrade reflects our view that the French government's current approach to budgetary and structural reforms to taxation, as well as to product, services, and labor markets, is unlikely to substantially raise France's medium-term growth prospects. Moreover, we see France's fiscal flexibility as constrained by successive governments' moves to increase already-high tax levels, and what we see as the government's inability to significantly reduce total government spending.

The stable outlook reflects our expectation that the government is committed to containing net general government debt, which we anticipate will peak at 86% of GDP in 2015.
...political room for additional revenue measures has lessened, in our opinion. Rising popular disapproval of incremental taxation has led to recent policy reversals. Combined with our view that the government has limited room to meaningfully lower spending over the 2013-2016 forecast horizon, we believe that France's revenue and expenditure flexibility has diminished. We had previously considered France's fiscal flexibility to be high compared to its peers. We now forecast a general government deficit of 4.1% of GDP in 2013, in line with the government's current target but above our previous expectation of 3.5% of GDP when we affirmed our ratings on France in November 2012.
The rating is constrained by the French government's elevated spending and tax levels, its high and still rising general government debt burden, and constraints on economic competitiveness. All these factors weaken France's growth prospects, in our opinion. 

Now let's analyze what hedge fund managers and economists have been saying about France in the media. Ray Dalio, founder and Co-CIO of the $150 billion hedge fund Bridgewater Associates, recently had negative views on France at the DealBook Conference on November 12, 2013.

As debt rises faster than income, which is continuing in France, and interest rates - both the base rate and the credit spreads have gone down to a certain level that they can't decline anymore - there's going to be a rise in debt service payments in France. And those rise in debt service payments are going to have an increasing constrictive nature on the economy. It's going to start to hurt that particular economy. At the same time, there's the rollover of debt. A lot more debt needs to be rolled over because it builds up and it compounds. And when it becomes more difficult, it's going to be more difficult to roll over that debt. And as that debt becomes more difficult to roll over, it starts to produce a funding gap. And it produces wider credit spreads. Wider credit spreads in turn make the debt service payments more problematic. And that process begins. So I think that it is a development that is a factor which will happen. I think that in terms of changing the landscape, it's put France in the category of southern European countries.

And on FT Markets on November 20, AXA Group Chief Economist Eric Chaney mentioned that the "divergence between the debt dynamics, government debt dynamics, in France and in Germany" could widen the 10-year French-German yield spread. He said:

Back before 1980, the German government debt was 10 points of GDP higher than the French government debt. Next year the German government debt will be almost 20 points of GDP lower than the French government debt. That raises an issue: If the two countries had two different currencies, that would be ok. But, is it possible to share the same currency when you have such a divergence?

Here is the chart he provided in the video. He also mentioned that Fed tapering could be a catalyst for the move.

Source: FT Markets, Financial Times



Investec is also betting on the French-German spread. "Investec sees euro crisis flare-up risk; short French bonds vs Bunds" (Reuters on 11/19/2013):

Peripheral bond yield compression has run its course, he says, while worries about the slow pace of reform in France keep him short on French as well as Italian bonds versus German Bunds.

France appears to be "heading south", he said, noting its weak leadership and diverging unit labour costs with Germany.

Links: 

*Eurozone Business Activity Rises but France Lags (AFP); Chart of Core vs. Periphery PMI Output Indices (French output is diverging with German output and the rest of the Eurozone via Markit's Flash PMI) (DistressedVolatility, 12/16/2013)

*Sharper fall in output at French companies in December (MarkitEconomics French PMI, 12/16/2013)

Fresh recession risk in France threatens political crisis (The Telegraph, 12/16/2013)

France on edge of return to recession, increasing pressure on Hollande (Guardian, 12/16/2013)

French stasis unnerves global bond investors (Reuters Summit, 11/18/2013)

France may be 'major pothole' in '14, says hedge fund star Hintze (Reuters Summit, 11/18/2013)

France : Reinforcing competitiveness is key to boosting jobs and growth (OECD, 11/14/2013)

Francois Hollande in crisis as France engulfed by 'exasperation and anger' (Telegraph, 11/14/2013)

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