Article / 26 April 2017 at 10:30 GMT

Weekly Bond Update: Macron paves way for higher rates

Fixed Income trader / Saxo Bank
Denmark
  • Bond investors rejoiced at the first-round election victory for centrist Macron
  • Far right's Le Pen would need to overcome big deficit to win election on May 7
  • 10-year German government yield jumped after first round of French vote
  • France fears had led investors to shield against re-denomination risk
  • With main political risk eliminated, focus swings back to economic fundamentals
  • Macron will still face big challenges to secure parliamentary support
  • ECB's Draghi not expected to announce any policy changes on Thursday
  • ECB will eventually need to react to economic momentum in Eurozone
  • Market could then find itself in a hurry to reflect that in bond yields
Emmanuel Macron
 Emmanuel Macron. The pro-Europe and market-friendly candidate's first-round 
victory set off a wave of relief in financial markets. Photo: Shutterstock


By Michael Boye


Financial investors around the world sighed with relief as the first round of the French presidential election produced a relatively comfortable win for the independent market-friendly and pro-EU candidate Emmanuel Macron. Lingering concerns that the far-right candidate Marine Le Pen, on the other hand, managed to sneak through to the run-off as well, are soothed by a still very wide margin between the two in opinion polls.

The fact that the initial polls actually held true (this time) in the first round adds to the comfort, and, even so, given the reported 20-point plus lead in head-to-head polling, which Macron has now held consistently for the past months, Le Pen would need to overcome a bigger deficit than Trump ever faced and come up with an unprecedented comeback to win the election on May 7.

Markets have rejoiced in response. In the weeks leading up to the election, we had seen a significant flight to safety, which for bond markets typically materialises in strong demand for German government bonds. 

The strength of these forces has surprised us a few times this year, but clearly investors have been very anxious about the wall of political uncertainty in Europe this year. The threats of a French exit from the euro and reintroduction of a new French franc, put forward by the Le Pen campaign, has even led to investors protecting themselves against re-denomination risk. That is investors moving into German bonds, as — presumably — the new German euro or the re-incarnation of the Deutsche Mark would be the strongest currency.

The 10-year German government yield jumped after the French election
Germany
 















Source: Bloomberg

The 10-year German yield dropped on the demand and reached a new low for the year, in the process bypassing any talk about tightening monetary policy from the European Central Bank. Now, with the biggest known political risk event in the rear-view mirror, the focus will swing back to economic fundamentals, and here there is no evidence of political risk interrupting momentum.

The latest Eurozone PMI survey, published last week, on the contrary, indicates the highest pace of economic expansion in years. As a consequence, inflationary pressures are now building, especially in Germany, where the opposition to the current aggressive monetary policy from the Draghi-led ECB is well known. Another of the most expanding countries? France, of course.

There's obviously more to monetary policy than PMI numbers, and Mario Draghi is not expected to announce any changes at the ECB's policy meeting on Thursday. But eventually the central bank will have to react to the economic momentum in the Eurozone, and, with political risk moving to the background, the market could quickly find itself in a hurry to reflect this in bond yields.

Eurozone PMI, which tracks sentiment among purchasing managers, is at multi-year highs
PMI
 
















Source: Bloomberg

As for Macron, he might go on to win the battle in next Sunday's second-round election, but the war won't be won just yet. The next challenge for the likely president elect, who is not member of any existing political party, will be to secure political support from the new parliament to be elected in June. 

France-Germany yield spread narrowed significantly after Macron's first-round victory
France















Source: Bloomberg

So, while the spread between French and German 10-year government bonds — the risk premium demanded by investors for assuming the added risk of lending to the French government instead of Germany — has narrowed significantly this week, a complete reversal to historical levels might still be months away. Chances are the Eurozone's second-largest economy could be engulfed in political instability for the foreseeable future.

French national assembly in Paris
 Macron will find it hard go govern if he cannot muster enough support in the 
national assembly after June parliamentary elections. Photo: Shutterstock


— Edited by John Acher

Michael Boye is a fixed income trader at Saxo Bank

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