France’s Market Rally Falters as Investors See Enduring Risk

(Bloomberg) -- Investors took comfort Monday that Marine Le Pen’s National Rally failed to record a decisive win in the first round of France’s snap parliamentary elections. The optimism is already fading.

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Stock and bond prices jumped at the open after Le Pen’s party finished with a smaller margin of victory than indicated by polls, and opponents began strategizing to keep her from winning a majority in the second round. The CAC 40 Index pared its gains by half and bonds quickly erased a rally to push yields up on the day. Traders are questioning whether prices can move much higher in the face of turmoil that could end with the far right in power.

Investors are fretting that a government led by the National Rally or the left-wing New Popular Front would pursue an expansive fiscal policy, adding to a swelling budget deficit. Other concerns stemming from Le Pen’s rise include the potential for greater political instability and even questions over the long-term future of the common currency.

“For me it’s still wait-and-see,” said Vincent Juvyns, a global market strategist at JPMorgan Asset Management. “I must say I’m a bit surprised by the market reaction. I think it’s clearly premature given the low visibility for this coming week. Both camps’ fiscal policies are disruptive for the French economy and the prospects for French debt.”

The CAC 40 stock index rose 1.7% at 2:10 p.m. in Paris after gaining as much as 2.8% in the first minutes of trading. Ten-year government bonds were little changed. Nonetheless, the yield spread over comparable German securities tightened by as much as seven basis points — trimming a more than 30-basis-point surge over the past two weeks — as traders exited haven securities.

The euro edged up, climbing as much as 0.6% to $1.0776, though it still remained weaker than where it was before President Emmanuel Macron called the snap vote in early June.

Macron’s centrist alliance and the left coalition now are weighing whether to pull candidates from the second round to keep the National Rally from securing an absolute majority on July 7.

For investors, the yield premium on French OATs over German bunds is a sign of the risk to France’s budget. At a projected 5.3% of output this year, the deficit already far exceeds the 3% of economic output allowed under European Union rules and its debt is expected to rise to 112% of economic output in 2024, according to the International Monetary Fund.

“While we expect some relief-tightening in OAT-Bund spreads, there is still uncertainty ahead,” said Evelyne Gomez-Liechti, a strategist at Mizuho. “Our analysis suggests that any significant tightening will be unstable given worrying debt sustainability dynamics.”

Le Pen’s National Rally locked up 33.2% of the vote, according to interior ministry figures. The New Popular Front got 28% and Macron’s coalition got 20.8%.

If alliances forming to block Le Pen from absolute power start to look credible, French markets would likely recover, according to Kathleen Brooks, research director at XTB.

“A hung parliament could make it hard to get anything done in France in the current parliament, which is exactly what the markets would like,” she said.

Shares of French banks Societe Generale, BNP Paribas and Credit Agricole all jumped on Monday, though they too pared their gains, while the riskiest type of bonds issued by French lenders rose the most in weeks in early trading. Banks have been under pressure since Macron called the election due to rising political risk and the drop in French sovereign bonds.

What Bloomberg strategists say...

If the leftist alliance “is aimed at blocking Le Pen’s grouping from getting a majority in the crucial second round, it has wide-ranging implications for the France-German spread and indeed the euro. If the upshot is that we will get a more centrist government, it would be positive for the currency and herald a narrower spread.”

— Ven Ram, cross-asset strategist for MLIV

Still, strategists warn there is likely volatility ahead, as the electoral calculus gets complicated in the runoff, and some point out that a hung parliament might not be much better for the nation’s finances than a far-right government.

“You have a situation between a hung parliament and a far right government so neither of those is particularly appealing,” said Marija Veitmane, senior multi-asset strategist at State Street Global Markets. “I myself would stay out of France.”

Volatility Is Only Certainty for Traders Parsing French Results

Macron’s decision to call a snap vote in early June had sent markets into a tailspin.

His party — which supports large spending cuts to get France’s budget deficit under control — suffered a crushing defeat in European parliamentary elections on June 9. National Rally, meanwhile, has touted some costly budget measures including lowering the sales tax on energy and fuel.

Over the past three weeks, the extra yield investors demand to hold 10-year French bonds over safer German debt rocketed to more than 80 basis points, levels last seen during the euro area’s sovereign debt crisis. The euro fell to its lowest since early May.

It’s hard to see a “material and sustainable snapback,” in French yields, said Peter Goves, head of developed market debt sovereign research at MFS Investment Management.

“Uncertainties are high, French fundamentals haven’t changed and the final outcome is still unknown and unknowable with the large number of three-way contests complicating matters,” he said.

--With assistance from Allegra Catelli, Farah Elbahrawy and Michael Msika.

(Updates market moves)

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