European financial markets brace for turbulence as the French parliamentary elections approach. ABN Amro’s rates strategist Sonia Renoult warns of potential fiscal instability and an unsustainable debt path for France.
Eurozone financial markets are bracing for weeks of heightened volatility with the upcoming French parliamentary elections. The first round is scheduled for Sunday this week, with the second and final round on 7 July.
Recent polling data from Harris Interactive, Ifop, Elabe, Ipsos, Odoxa, OpinionWay, and Cluster17 indicate that Marine Le Pen’s National Rally (RN) is leading with a median 35.4% of preferences, followed by the far-left New Popular Front (NFP) at 28.1%, and President Emmanuel Macron’s Renaissance at 20.8%.
These polling results suggest a potential second-round contest between far-right and far-left coalitions, potentially sidelining Macron’s centrist parties.
Sonia Renoult, rates strategist at Dutch bank ABN AMRO, recently offered valuable insights into the potential impact of the French parliamentary elections on the country’s fiscal policy and European sovereign debt markets.
She noted: “France’s government finances were already in a parlous state”, even before Macron’s snap election call, adding that “the prospect of a less fiscally responsible new government” could exacerbate the situation.
France’s government debt on an “unsustainable path”
Renoult emphasised that: “In any of the possible scenarios described, France’s fiscal deficit is unlikely to go back to the 3% deficit target by 2027.”
ABN AMRO’s baseline scenario predicts that the RN party will gain a relative majority in parliament, leading to a cohabitation government with President Macron.
Market concerns centre on the possibility of unsustainable fiscal policies and a less cooperative stance towards the European Union (EU).
Both far-right and far-left parties advocate for expansionary fiscal policies and express significant opposition to EU integration.
The RN’s policy proposals indicate significantly higher government spending compared with the current administration. Key measures include indexing pensions to inflation (€27.4bn), lowering the retirement age from 64 to 62 (€22bn), and reducing VAT on energy from 20% to 5.5% (€11.3bn).
However, Renoult highlighted: “Some measures will be difficult to implement due to constitutional constraints.” Additionally, the proposed VAT reduction on energy conflicts with EU law, which requires a minimum rate of 15%.
The RN also aims to cut its contribution to the EU budget by €2bn, a move that is unlikely to succeed but could still cause political friction with the EU.
Under the current proposals, an RN-led government would result in persistent deficits above 6% in the coming years.
If an NFP-led government comes to power, it could lead to a deficit approaching 8%, Renoult warned.
“The net effect would still put government debt on an unsustainable trajectory,” the analyst added.
How could French and European bonds react?
In a worst-case scenario, financial markets, coupled with European authority pressure, could hasten France’s fiscal reckoning, according to ABN Amro.
Since the announcement of the snap election, French bonds have significantly underperformed and the Dutch bank expects OAT-Bund spread to remain wide until there is clarity on the election outcome and subsequent policies.
The underperformance of French bonds has led the 10-year bond yield to trade above its Belgian counterpart and align with, or slightly exceed, those of peripheral countries such as Portugal, which have lower credit ratings.
After the final round on 7 July, the direction of French bonds will depend on the governing party for the next three years.
This fiscal uncertainty casts a shadow over France’s economic outlook. “”In a scenario where a future French government ploughs ahead with a fiscally reckless plan, this would likely cause the market to lose trust in the country’s debt and push the 10y French spread well over the 100bp level,” said Renoult.
Such a scenario could result in France being traded similarly to lower-rated countries, effectively becoming a “crossover peripheral”.
Moreover, since the European Commission has placed France into its Excessive Deficit Procedure, the European Central Bank cannot utilise its Transmission Protection Instrument to mitigate the country’s sovereign credit risk. Therefore, Frankfurt would need to devise an alternative emergency programme to mitigate further fragmentation risks within the currency bloc.
According to Renoult, this situation may present “attractive opportunities” for investors looking to re-enter the European debt market once political uncertainties ease, enabling them to purchase debt from countries with strong economic fundamentals, such as Spain or Portugal, at more favourable yields.