Macron's gamble spooks French bond markets

French bonds sold off hard after Emmanuel Macron dissolved the National Assembly and called snap parliamentary elections, following a heavy defeat in the European elections. The gap between yields on French ten-year OATs and German Bunds widened faster than at any time in a decade.

A defeat, then a dare

The trigger was Sunday's vote. Marine Le Pen's National Rally, with Jordan Bardella at the top of its list, won more than twice the share of Macron's alliance, and within hours the president called a two-round election for 30 June and 7 July. The move is a dare to voters to choose between his centrists and the extremes. It gives markets less than a month to price a government whose programme nobody yet knows.

The arithmetic of the Assembly explains the unease. There are 577 seats, and a party needs 289 for an absolute majority; Macron's camp lost its majority in 2022 and has governed since then by forcing budgets through without a vote. Under the two-round system, the result depends on which candidates clear the threshold for the run-off and on the deals parties strike between rounds. The left has already moved to field joint candidates, which makes a three-way split more likely than a clean win for anyone.

Pricing a hung France

Investors fear that a win for Marine Le Pen's National Rally or for a left-wing coalition would bring looser budgets, with pension reforms reversed and deficits allowed to grow in defiance of European Union rules. France already runs a deficit of more than 5.5 per cent of GDP. Political turmoil on top of that has raised the risk premium on French debt, probably for some time.

The fiscal starting point was weak before Sunday. Public debt is above 110 per cent of GDP, and Standard & Poor's cut France's rating to AA- only at the end of last month, citing slippage on the deficit. The European Commission is expected to recommend an excessive-deficit procedure against France this month, the first test of EU fiscal rules that came back into force this year after their suspension during the pandemic. The 2023 pension reform, which raised the retirement age from 62 to 64 and was forced through the National Assembly without a vote, is the obvious target for any new majority.

Ratings add a mechanical element. Fitch already cut France to AA- in April last year, so two of the three big agencies now sit at the same notch, and further downgrades would push some conservative investors with rating-based mandates to trim holdings. A French government bond is still investment grade by a wide margin, but the market has long treated France as a near-substitute for Germany, and that assumption supported demand from central banks and reserve managers abroad.

How the risk spreads

The damage travels through a few channels. A wider spread raises the cost of every new OAT the Treasury sells, and France has to refinance a large stock of debt every year. French banks, which hold plenty of their own government's bonds, sold off with them, since their capital moves with the value of those holdings. Bunds are the main beneficiary, as investors seeking a safe euro asset move to Germany, and the euro itself slipped against the dollar.

French households are exposed as well, if less visibly. Much of their savings sits in life-insurance contracts whose guaranteed funds are invested heavily in government bonds, so insurers carry a large block of OATs on behalf of ordinary savers. A lasting rise in yields helps those savers over time through higher returns on new money, but it hurts the market value of the bonds already held and limits what insurers can pay out if policyholders rush to withdraw.

A backstop with conditions

Investors naturally ask whether the European Central Bank would step in. In July 2022 it created the Transmission Protection Instrument, which allows it to buy the bonds of a country whose spreads widen in a way it judges disorderly and unwarranted. The tool comes with conditions, though, and one of them is compliance with the EU's fiscal framework. A French government that tore up its deficit commitments while under an excessive-deficit procedure would struggle to qualify, which means the ECB's protection is weakest in exactly the scenario markets fear most.

Precedents in Rome and London

Markets have punished fiscal defiance before. In 2018 Italy's populist coalition clashed with Brussels over its budget, and the spread between Italian and German ten-year yields climbed above 300 basis points before a compromise was reached. In 2022 Britain's unfunded tax cuts triggered a gilt crisis that forced the Bank of England to intervene and brought down a prime minister within weeks. France's own worst recent spell came at the height of the euro crisis, in January 2012, when S&P stripped it of its AAA rating.

Why it may not last

The case for calm deserves a hearing. France has lived through cohabitation three times, in 1986, 1993 and 1997, without a fiscal crisis, and the constitution leaves the president real powers. The National Rally long ago dropped its plan to leave the euro and now courts business, and a party that wants to win the next presidential election has reasons not to preside over a bond rout. Domestic savings are large, and the OAT market is among the deepest in the world. Those points limit the downside, but they do not remove the political uncertainty that is now being priced.

The dates to watch are the two rounds of voting, the Commission's recommendation, and the next rating reviews. After that comes next year's budget, due in the autumn, which will be the first document to show whether a new government intends to reduce the deficit or merely to talk about it.

Macron's gamble ended the bond market's easy assumption that France was safe. Whoever wins, French borrowing costs will probably stay higher relative to Germany's until a new government shows it can keep the deficit in check. The spread will not settle before the second round on 7 July at the earliest, and the likelier outcome is a hung Assembly that leaves the premium in place through the autumn budget, with the French Treasury, French banks and their insurers paying for it.