Why French bond markets may be headed for big trouble

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The European bond markets are getting the message. The French election is turning into a tight, four-way race – a cliffhanger – and two of the four leading candidates have no love for the European project.

Eleven days ahead of the first round of the presidential polls, bond investors are getting skittish. The best measure of their sense that political and economic risk is intensifying in France, the euro zone's second largest economy, is the widening gap, or spread, between benchmark French sovereign bonds and their rock-solid German counterparts.

On Tuesday, 10-year French bonds traded at a spread of 76 basis points over 10-year German bonds (100 basis points equals one percentage point). That's high, and just a single basis point short of the four-year peak, hit in February. In March, the spread was less than 60 basis points.

The French two-year notes are registering even higher risk. Their spread over equivalent German debt is at the highest level since the euro zone crisis, which peaked in 2012 when European Central Bank president Mario Draghi unleashed his rescue-Europe campaign. The widening spreads mean that a classic hedging strategy is in place. Investors are dumping French bonds, pushing down their price and sending their yields in the opposite direction, and buying less risky German bonds. "French political risk is back," ABN Amro analysts Aline Schuiling and Kim Liu said in a clients' note.

What's behind this trade? It's the polls.

Marine Le Pen, leader of the anti-immigrant and anti-euro National Front party, is still ahead, barely, in the polls. The race is getting highly competitive and the rising star is the far-left candidate Jean-Luc Mélenchon, who was a crowd pleaser in the candidates' two televised debates with his "soak"-the-rich message and Euroskeptic views. The 65-year-old former member of the centre-left Socialists has said the European Union has become polluted by neoliberalism and that, if elected, he would haul France out of the EU, Brexit-style, unless its treaties were overhauled.

Until two or three weeks ago, Mr. Mélenchon was considered a maverick candidate with no hope of making the first-round cut (in the presidential election, the top two candidates in the first round, assuming neither wins 50 per cent or more of the votes, battle for victory in the second round, on May 7).

But the latest polls, published by Ifop-Fiducial, put him a mere 0.5 percentage points behind François Fillon – the Republican candidate who wants to shrink the state drastically – at 18 per cent. The two are essentially tied for third place, a remarkable achievement considering that Mr. Mélenchon was polling at 12 per cent or less not long ago. The ABN Amro analysts said Mr. Mélenchon's rise "is bad news for French bonds."

The poll leaders remain Ms. Le Pen, at 24 per cent, and the pro-EU centrist candidate Emmanuel Macron, at 23 per cent. It's feasible that Mr. Mélenchon's popularity could rise to 20 per cent by the first-round election, on April 23, and that Mr. Macron's could slip. Mr. Macron's problem is that a lot of voters who say they are tempted to vote for the 39-year-old former investment banker, who was economy minister between 2014 and 2016, have not made up their minds.

As the polls have tightened, the rival leading candidates have gone after Mr. Macron, accusing him of being one of the architects of France's dismal economic performance in recent years. While the French economy did not collapse during the crisis years, the country continues to suffer from high unemployment, at about 10 per cent, and painfully high youth unemployment, at 25 per cent – more than three times the German rate. Growth has been weak, the budget deficit is running higher than EU rules allow and deindustrialization has laid waste to big sections of the economy.

The scenario in which Ms. Le Pen and Mr. Mélenchon knock out Mr. Macron in the first round, while still unlikely, is no longer pure fantasy – the bond markets are responding to this. While conservative voters, Big Business and the banks would not support Mr. Mélenchon, remember that the anti-establishment mood is fairly strong in France and his hard-left stand could be as much as an asset as a liability. Speaking recently in Marseille, he said that supporters of the neoliberal agenda of free trade, deregulation, privatization and low taxes for the rich "transforms suffering, misery and abandonment into gold and money."

The polls say Mr. Macron, who is running on an independent ticket that is neither left nor right, would beat Ms. Le Pen in the second round. He would keep France in the EU and in the euro. But if Mr. Macron is knocked out, two Euroskeptics – Ms. Le Pen and Mr. Mélenchon – would move into the second round and one of them would become president.

That scenario would put the French bond markets into full crisis mode. Ms. Le Pen wants out of both the EU and the euro. Mr. Mélenchon is not promising a referendum on EU or euro membership, but it could get to that if any renegotiated EU treaties don't give him the flexibility he wants. Buying French bonds today constitutes an act of bravery.