France’s debt: too heavy to lift, too big to spot

At around 150 basis points over Bunds, French ten-year government bonds look tempting. The spread is exceptionally wide by France’s historical standards. For investors accustomed to treating France as a core European sovereign, the instinct is to buy the dislocation and wait for normality to return.

But that instinct risks anchoring to a past that no longer provides a reliable guide. A spread can be historically wide and still offer inadequate compensation for what lies ahead.

A couple of years back, I argued that France’s fiscal pressures and political fragmentation threatened more than its own creditworthiness. They challenged the cohesion of the eurozone itself. I more recently questioned another assumption underpinning European sovereign valuations: that Germany would always have the economic strength and fiscal capacity to support the rest. Those two concerns are now coming together with worrying implications.

Investors should therefore consider a different reference point: Italy’s historical spread over Germany. Italian spreads exceeded 500 basis points during the sovereign debt crisis That is not a forecast for France, but it demonstrates how far spreads can move when markets lose confidence in fiscal sustainability and the credibility of European support. France’s own trading history may be a poor measure of its potential downside in a different regime.

The central problem is moral hazard. Providing unconditional support to France would weaken the incentive to repair its public finances and invite other governments to expect similar treatment. Yet withholding support risks allowing higher borrowing costs to worsen the fiscal position and transmit stress across the monetary union.

The ECB’s tools do not remove this dilemma. Its Transmission Protection Instrument considers fiscal sustainability and compliance with European policy commitments, and is intended to address unwarranted, disorderly market pressures. A repricing driven by deteriorating fundamentals presents a much harder case for intervention. 

In my view, durable support would require a concerted French effort to restore fiscal credibility. The approaching presidential election complicates that bargain: European institutions need confidence that the government making commitments can deliver them and that its successor will honour them. There is no formal requirement for the ECB to wait until the election, but political clarity may be necessary before meaningful conditions can be sustained.

Germany’s changing position makes this more difficult. It can remain the relative haven within Europe while becoming less able or willing to underwrite its neighbours. Bund outperformance during a crisis would not prove that the capacity for collective rescue is unlimited..

An interesting expression of this risk is to short Spanish government bonds against duration-matched Bunds. My argument is that Spain’s still relatively tight spread offers too little compensation for a broader fragmentation episode. A narrower starting spread also means less negative spread carry than shorting France.

Spain offers a potentially inexpensive way to position for investors questioning the eurozone’s collective insurance policy, with relatively limited downside. Let’s not forget Spain does have a debt to GDP ratio of 100% and is governed by a minority Government who just yesterday called a snap election. A tempting asymmetry given the growing risks.

France at 150 basis points may look cheap against yesterday’s France. Investors should be extremely cautious about assuming that yesterday is coming back.