Global Daily – No French revolution

by: Nick Kounis , Aline Schuiling , Kim Liu , Tom Kinmonth

Euro Politics: Frexit risk fades, but don’t expect Macron revolution – There is good news and bad news following the market-friendly outcome of the first round of the French presidential elections. The good news is that the nightmare scenario for markets of a Marine Le Pen and Jean-Luc Mélenchon run-off has been avoided, with the Frexit tail risk diminishing further. Predictably, financial markets responded by pricing out the Frexit risk premium, leading to a rise in the euro, French government bonds and risk sentiment more widely (see below). Mr Macron will very likely win the second round and he has a positive economic agenda. The bad news is that he will face serious obstacles in implementing that agenda. Even presidents with the best intentions have struggled to pass reforms in France. They have been blocked by vested interests, street protests and strikes in the past. Macron will likely also face the obstacle of not having a parliamentary majority. Under France’s semi-presidential political system, if a president’s party is different to that of the majority of members in parliament, the government is divided – this is called “cohabitation”. When this happens, the President can become a marginal figure in national politics. For more, please see our note Eurozone Watch – Macron set for presidency (Nick Kounis & Aline Schuiling).

170424-Global-Daily.pdf (49 KB)

Euro Rates: French spread compression justified, peripheral rally overdone – The EGB market opened with a bang. At market open, the 10y bund yield rose by 7bps to 32bps and schatz/bobl/bund asset swaps tightened. However, as could have been expected, improved risk sentiment was most visible in semi core and periphery. The yields of 10y Belgium, France, Ireland, Spain and Italy narrowed compared to those bunds by around 20bps. The French-German 10y spread tightened to a low of 46bps taking it to the lowest level since January. At the end of the day, some movements retraced but most of the gains were maintained. It seems that the market is pricing out France-related Euro breakup risk from Italian bonds, which explains the outperformance of Italian debt. However, Italy has plenty problems of its own. The Eurosceptic party MS5 is at the top of the polls and elections are due at the start of next year. Furthermore, Italy’s toxic combination of weak economic fundamentals, high government debt and a troubled banking sector continues to be a worry going forward. In addition, with the benign French outcome, the ECB is free to continue moving towards the QE exit. These three factors make Italian bonds particularly vulnerable and should put Italian spreads under renewed pressure. We therefore stick to our forecast of 240bps over 10y bunds at the end of 2017. For more, please see our note Euro Rates Watch – French relief dominates market opening – for professional clients, please see disclaimers in the document. (Kim Liu)

Euro Banks: French election result positive for banks – We also see positives for the French banks from the increased likelihood of a Macron presidency. French bank debt performance had significantly lagged other European countries this year, an excess return of just 0.40%, versus 0.89% for the index. This performance was the weakest of any major country in the European index. However, sentiment changed today as ‘Frexit’ risk receded further. French bank funding costs reduced greatly, as their bank debt market rallied on the election news. Some Tier 2 issues of French banks tightened phenomenally, over 20bps. We still favour Tier 2 French debt over Senior Non-Preferred paper, often for 40bps of pickup. The second part of the positive performance for French banks, was that Macron announced in February that he wished for European finance ministers, not regulators, to set capital rules for banks and insurers, which could over time lower capital requirements. France has four banks classified as being systemically important, joint second in number with the UK, after the United States. This leads the French banks to have, relative to other countries, high capital requirements. The first capital requirement hurdle comes in the form of total loss-absorbing capacity (TLAC) requirements which begin in 2019. We do not think the four major banks in France will have adjusted capital requirements before this date, but there could be eventual shifts in the longer term, especially combined with policy shifts across the Atlantic. For more, see our notes Financials Watch – French election, positive for French banks and Covered Bond & RMBS Comment – Positive French result, as issuance collapses  – for professional clients, please see disclaimers in the document. (Tom Kinmonth)