Eurozone risk premiums push wider amid French election uncertainty and fresh Greek debt woes
Developments in the eurozone were the focus of investor attention over the past week, with spreads in the periphery moving wider on growing angst with respect to the upcoming French presidential election. The outcome of May’s vote seems highly uncertain, with support for the Republican candidate, Francois Fillon, continuing to wane. Marine Le Pen continues to lead opinion polls based on the first round and although it appears likely that she would lose to a centrist candidate such as Emmanuel Macron, there is a risk that were the Socialist candidate, Benoit Hamon, to make a pact with Jean-Luc Melenchon (say by offering him a role as Prime Minister), French voters could end up with a choice between a candidate on either the hard right, or the hard left of French politics in the second round of voting.
Such an outcome could be highly problematic with respect to the future of France and could stress the stability of the eurozone, potentially pushing it towards a breaking point. Although we feel such an outcome will ultimately prove unlikely, the uncertainty of a campaign characterised by a majority of the French electorate seeming to support candidates on the political extremes means that the political risk premium has grown in recent weeks and looks unlikely to dissipate until there is much more clarity.
Greece has also been making headlines, with the IMF questioning debt sustainability, putting more pressure on Brussels to agree on a debt restructuring of official sector holdings. We believe that such a move is highly unlikely ahead of the French and German elections, and Paris and Berlin are probably desperate for this not to become a bigger issue in the next few months. Ultimately we expect the European Stability Mechanism will agree to lower interest rates on loans and a lengthening of maturities in order to reduce the burden on Greece on a net present value basis. However, confrontational headlines have seen Greek bond prices fall, with 2-year bonds now yielding 10% (up from 7.5% at the end of last year). Nevertheless our judgment is that Brussels won’t try to push Greece out of the Euro and domestic polls from Greece show rising support for New Democracy, and little enthusiasm to leave the single currency, regardless of what Trump’s candidate for EU Ambassador may have to say on the matter.
More broadly, the negative news flow coming from France and Greece has pushed spreads wider across the eurozone. 10-year Italian government bonds (BTPs) reached a three year wide at 200bp over Bunds, whilst the yield on the 10-year Portuguese government bond touched 4.5% - beginning to approach levels where market access risks being lost, with Portugal exposed to the possibility of needing a renewed support programme. In France, government bond (OAT) spreads briefly topped 80bp over Bunds taking the spread back to levels last seen in the midst of the eurozone sovereign crisis in 2012, before retracing from these levels. More generally this backdrop created something of a flight to quality in European assets, pushing equities lower and credit spreads wider. G3 government bond yields pushed lower as a result in a week where there has been relatively little economic data to drive prices. Nevertheless, US equity prices continued to print new record highs, helped by prospects of robust growth and muted inflationary pressures based on last weeks’ labour market report.
Elsewhere, in the US, there was more of a sense of Trump getting down to business with the furore surrounding his travel ban starting to recede. Comments from the office of the President suggest that he wants to announce something on taxation policy in the next 2-3 weeks, though based on our discussions with policy makers we think that a clearer outline of budget proposals will only emerge at the end of March or early April. With respect to the Federal Reserve (Fed), it appears likely the David Nason will be appointed to the board for one of the two vacant slots, taking responsibility for Wall Street regulation. We are likely to need to wait longer for the announcement of the other open slot, but following Kevin Warsh’s recent op-ed in the Wall Street Journal, it is possible that he is now emerging as a front runner as the candidate as the potential next Fed Chair.
Looking forward, next week sees Yellen’s testimony and also US consumer price index (CPI) data. With very little priced into markets with respect to a possible March rate hike (current odds at 12% based on Fed Funds contracts), we see potential scope for a hawkish surprise and with some of the weaker hands pushed out of duration shorts, it may now be easier for yields to push to the upside were this to occur. We would note that inflation has been surprising on the upside on a global basis and in this regard US data has been surprisingly benign of late. We would not be surprised to see an inflation print above 2.5% and in this light, we expect the past weeks’ rally in yields to be reversed. We remain convinced on our macro call on the US economy at this point in time and away from day to day price action; we feel it is a time to keep a steady hand and a cool head, maybe unlike a certain tennis player from Canada in his Davis Cup tie this week...
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Image credit: Ted Pink / Alamy Stock Photo
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Published February 2017