Why France’s Debt Woes Haven’t Spooked Europe

Protests at Place de la Republic square in Paris on Oct. 6. (Dimitar Dilkoff / AFP via Getty Images)

Key Points

• The yield on French sovereign 10-year bonds has soared past those of Italy and Greece as a divided National Assembly is deadlocked over a budget.
• Investors are divided on whether French sovereign debt is a buy, but few expect a rerun of the regional eurozone crisis from 2010 to 2012.
• French Prime Minister Sébastien Lecornu proposed a 2027 budget on Oct. 1 that would hold the country’s deficit line at 5% of gross domestic product.

What’s happening in France is staying in France bond-wise for now. That’s a good thing.

The yield on French sovereign 10-year bonds has soared past those of Italy and Greece, as well as those of corporate issuers such as beauty giant L’Oréal . A divided National Assembly is deadlocked over a new budget, while student-led protests have created havoc in the streets across France.

Investors are divided on whether French sovereign debt is a buy at current prices. Few are expecting a rerun of the regional crisis that shook the euro zone from 2010 to 2012, when Greece had to restructure its debt —and bond yields soared across the continent’s Mediterranean rim.

“France has a problem, not Europe,” says David Zahn, head of European fixed income at Franklin Templeton.

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The Fifth Republic, with budget deficits at 5% of gross domestic product, is an outlier these days in a continent that has broadly tightened its belt, starting with the PIGS group of countries—Portugal, Italy, Greece, and Spain—that were the problem children during the 2010-12 crisis. Yields on 10-year paper from Germany, the continent’s financial anchor, have risen 40 basis points, or 0.4 percentage point—less than the yield on the 10-year Treasury note’s 120 basis-point gain over the past year—a sign of market confidence.

The European Central Bank has also grown into the role of stabilizer of last resort. Then-ECB president’s Mario Draghi’s pledge of “whatever it takes” in July 2012 to buy bonds from euro zone countries if necessary might seem prescient now. “The ECB learned from its mistakes and realizes it is the ultimate backstop for the economy,” says Davide Oneglia, head of European and global macro at TS Lombard.

French bonds’ spread over German Bunds, the market’s go-to metric, has inched down from nearly 160 basis points on Oct. 2 to 140 on Oct. 9, as buyers cautiously emerged. One is Nick Verdi, global rates and FX strategist at TCW Group. “We added to France last week,” he says. “There’s a dislocation relative to fundamentals.”

France’s $3.4 trillion economy is like “a company that throws off a lot of cash but misallocates capital,” says Jeremie Peloso, European macro strategist at BCA Research. Rock-bottom ECB rates have kept government interest payments below 2.5% of France’s gross domestic product, while the U.S. is pushing 3.5%. “From a revenue stream perspective, the bonds are quite enticing,” Peloso says.

Fractious political leaders in Paris are at least beginning to discuss fiscal consolidation, says Ed Al-Hussainy, global rates strategist at Columbia Threadneedle Investments. Embattled Prime Minister Sébastien Lecornu on Oct. 1 proposed a 2027 budget that would hold the deficit line at 5% of GDP. Marine Le Pen, leader of the National Rally party and the front-runner in next spring’s presidential election, responded with her own budget slashing targets, though details were light.

“The mood music has changed,” Al-Hussainy says. “At these premium levels, it just has to go from terrible to bad.”

That doesn’t mean France’s situation can’t get more terrible in the short term. Precedent isn’t encouraging, Zahn observes. “This republic has never managed to consolidate,” he says. (It was founded by Charles de Gaulle in 1958.) “When the spread over Bunds gets to 200, it will start to become interesting.”

The next president, who will likely be chosen in a runoff vote in May 2027, will probably still lack a majority in the National Assembly, Peloso predicts, which he says minimizes the chances for the most essential reform—reining in “the world’s most generous pension system.” Le Pen, despite her newfound fiscal hawk rhetoric, is sticking with a pledge to cut the retirement age from 62 to 60. She also supports slashing taxes on energy for consumers.

Asian investors who historically dip-buy European debt are staying away from France so far, perhaps drawn by improving yields in Japan, adds Johnathan Owen, an investment-grade portfolio manager at TwentyFour Asset Management. “As a multiyear trade, France does make sense,” he says. “We’re not stepping in because no one has any conviction.”

Markets will be watching two signposts over the coming months, aside from whether the student-led protests will escalate or dissipate. The first is whether Le Pen works with Lecornu on passing a budget by a year-end deadline. “If the budget passes, the Bund spread goes below 100 basis points,” TCW’s Verdi predicts.

If it doesn’t, more political chaos could ensue. The government could implement its budget without parliamentary approval, risking a no-confidence vote from lawmakers. Or the 2026 budget remains in force without the cuts in Lecornu’s 2027 proposal. (The current budget’s “rollover provision” at least keeps France immune from government shutdowns.)

Less-heralded are upcoming credit reviews from Moody’s and S&P, two of the Big Three global bond credit-rating firms, says Robert Tipp, head of global bonds at PGIM Fixed Income. Moody’s has a negative outlook on its Aa3 rating for French sovereign credit, with a review scheduled for Oct. 23. S&P, which is slated to review in November, is already a notch lower at A+. “French yields will crest over the next nine months,” Tipp predicts. But bad news from the agencies could push the crest higher.

For the rest of the EU, 33 years after the Maastricht Treaty set the union’s current ground rules, four of its five top economies are within—or close to—the pact’s 3%-of-GDP deficit stricture. France is the exception. “From a fiscal perspective, Europe is preferable to the U.S.,” Tipp says.

Growth is another story.

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