The risk premiums on government bonds in several Euro-area states have increased significantly in the past few days. Italian as well as French government bonds have come under especially heavy pressure. The gap between ten-year Italian and German yields rose recently to 200 basis points and thus to the highest level since 2014. The yield spread between French and German bonds of the same maturity is now around 70 basis points – a new four-year high.
The most important reason for these rising yield spreads is the perceptibly higher level of political uncertainty in these countries. Prominent here is yet again Italy, which has still not recovered politically from its failed reform of the Senate. Although early elections are not politically necessary, they are possible as of the late spring now that the Constitutional Court in Rome has ratified parts of the electoral law. The populist Five Stars Movement, which is in favour of putting an end to the austerity policy as well as of a referendum on the country’s future in the euro, could emerge victorious from these new elections. But the Social Democrats, who are still in power under the new prime minister Gentiloni, are also increasingly turning their backs on the austerity policies of earlier days. With the rating agency DBRS having recently withdrawn Italy’s last A rating in mid-January, Moody’s will be the next to assess Italy’s credit standing. In addition, the banking crisis in Italy is still far from being resolved. The situation is so difficult that even the ECB is now bringing a European bad bank into play to absorb – among others – the large number of non-performing loans from Italy. So the uncertainty in the market for Italian government bonds, which since the beginning of the year has also had to cope with a flood of new issues, is likely to linger on for some time to come.
At all events France will be electing a new Parliament as well as a new head of state this year. The Republican candidate for the presidency, Fillon, had got off to a good start in the election campaign with premature praise from investors, but now – dogged by ongoing accusations of corruption – he is in political difficulties. While his star is increasingly on the wane, the candidate of the right-wing populist Front National, Le Pen, is now even in the lead in the polls for the first round of voting. Her chances of making it to the run-off vote are therefore very good. Le Pen started her election campaign officially last week-end and sounded the expected nationalistic and protectionist notes. Although Le Pen plans to continue France’s EU membership if she wins the presidential election, it will take on a different form than in the past. She is also calling for withdrawal from the Euro and NATO.
The markets’ reactions show that investors are increasingly getting used to the idea of Le Pen winning the election and thus to what they consider to be the “worst-case scenario”. While Trump’s surprising victory in the USA shows that the opinion pollsters do not always get it right and while nothing can be ruled out more than two months before the first round of voting, Le Pen’s prospects of really becoming president are nevertheless anything but good. A clear majority of the French rejects Le Pen as a possible president and in a run-off election would presumably give their vote to the corresponding rival candidate regardless of who this is and what his political orientation is. So it does not come as a surprise that it is not Le Pen who is the main political beneficiary of the affair surrounding Fillon but the former Minister of Economic Affairs, namely the liberal independent candidate, Macron. Polls now see him as Le Pen’s likely challenger in the run-off election, from which Macron should emerge as winner with a large lead. As things stand, the French would even vote for Fillon – some possibly grudgingly – in a run-off election just to stop Le Pen. This shows that while right-wing populism in France is gaining in strength, at the present point in time it is not yet able to muster a majority.
Against this background, we believe that anticipating a Le Pen victory as an increasingly likely scenario is an exaggerated reaction on the part of players in the French government bond market. The situation in France, therefore, differs significantly from that in Italy even though so far the markets fail to make an adequate distinction between the two.