European Bond Spreads In A Duel With The 'Bad'

(MENAFN- ING) European government bond markets – in a duel with the“Bad”

European government bond spreads have returned to the market's focus. Importantly, spread moves are not purely idiosyncratic country stories. They also reflect broader risk sentiment, and higher interest rate volatility generally pushes spreads wider. At the onset of the Middle East turmoil, for instance, we saw sovereign spreads become more closely correlated with energy prices and expectations for European Central Bank rate hikes.

But high deficits – the“Bad”– and existing fiscal imbalances have made some countries more vulnerable than others, and these factors are increasingly shaping the dynamics of sovereign spreads. The“Bad” has re-entered the scene and is once again dominating the narrative in parts of the European government bond market.

While France is already being singled out as a risk factor with the potential to change the broader outlook for European sovereign debt, Europe's busy election calendar suggests that idiosyncratic drivers could become more important overall. Spain goes to the polls later this month, and Italy will have to hold legislative elections before the end of next year. Finland will also hold parliamentary elections, while Germany faces elections in five federal states. And that is just to name the most prominent.

As markets navigate these political and fiscal risks, we expect spreads to remain at wider levels through much of the first half of the year.

Markets have reordered the EMU countries over the years, and have now singled out France Source: IMF, Refinitiv, ING

"> France – Facing the very“Bad”, the one that could change it all

Moody's recently affirmed France's last remaining double-A rating but maintained a negative outlook. The underlying assumption is that a 2027 budget containing at least some fiscal consolidation will eventually pass, even if this requires the use of a decree. That would represent a step in the right direction and could offer French government bond spreads some welcome relief going into the new year.

Beyond that, however, a“significant and sustained fiscal effort” will still be required. The outlook is clouded by the 2027 presidential election, with the two voting rounds on 18 April and 2 May. The far-right's Marine Le Pen, the current leading contender, could subsequently call snap legislative elections in the summer in an attempt to break the parliamentary deadlock.

The benign scenario would be one in which Le Pen wins and follows through on her promises of fiscal consolidation. In that case, spreads could return towards levels seen before September, and France could conceivably trade tighter than Italy again. There is, however, still a long way to go before such an outcome can be taken for granted.

If Italy is the yardstick for a proper crisis, there is still room for escalation Source: Refinitiv, ING

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The consolidation plans presented so far by Le Pen appear unrealistic, while the French public does not yet seem prepared to support the scale of adjustment that would ultimately be required. Against that backdrop, the market is likely to continue demanding a sizeable political risk premium. In the absence of positive catalysts, we see a 10-year OAT-Bund spread in the area of 150bp as a floor during the period of electoral uncertainty.

The tail risk is that public discontent instead translates into stronger support for the far left and Jean-Luc Mélenchon, whose proposals have included highly controversial ideas such as cancelling French debt held by the Bank of France. A greater probability being attached to such an outcome could push the 10-year OAT-Bund spread beyond 200bp.

More broadly, the absence of a credible multi-year consolidation plan, combined with the possibility of another hung parliament, would leave the door open to further sovereign rating downgrades, and not just from Moody's. In an unscheduled update, Fitch only recently lowered the outlook of France's A+ rating to negative. Under such circumstances, spreads could remain noticeably above 100bp even once the immediate electoral uncertainty has passed.

That said, we believe current spread levels already extend beyond what fundamentals alone would imply. The market is effectively pricing French debt as though it were already rated BBB. But prolonged and exceptionally high country-specific uncertainty, combined with elevated volatility in broader interest-rate markets, keeps valuations unattractive for many investors. One big risk is that structural foreign investors, which have historically been attracted by France's large, liquid bond market, start abandoning the credit. While data through August do not show any larger shifts, Japanese investors, for instance, have already shown themselves to be sensitive to French election risk in the past.

French has a large foreign investor base which has looked fickle around elections Source: Bank of Spain, Bank of Japan, ING

"> The ECB can cap spreads, but does it want to?

In theory, the European Central Bank has both the instruments and the firepower to rein in sovereign spreads. But as long as the turmoil remains largely contained to France, we think the central bank will be inclined to let market mechanisms play out, thereby maintaining pressure on French politics to address the underlying fiscal issues. The ECB has historically been careful to avoid creating the impression of moral hazard.

If needed, the first and least targeted response would be to dial back hawkishness or even halt the tightening cycle. That might appear an easy way to calm markets. But as long as energy prices remain elevated and concerns about second-round inflation effects persist, there is a limit to how far the ECB would be willing to go solely in response to wider sovereign spreads.

A more targeted option would be to suspend quantitative tightening by resuming reinvestments. The ECB could even frame such a move as part of a broader adjustment of its balance-sheet policy, particularly as excess liquidity in the banking system approaches levels at which demand for central bank refinancing is expected to become more important. In theory, liquidity operations should take over at that stage. But as long as borrowing from the ECB continues to carry some stigma for banks, ending QT and resuming reinvestments could address two issues at once: easing pressure on sovereign bond markets while also slowing the decline in excess liquidity.

If turmoil were to spread further beyond France and threaten the transmission of monetary policy, the ECB could ultimately deploy its Transmission Protection Instrument. TPI comes with eligibility considerations, including compliance with the EU fiscal framework and debt sustainability, both of which would clearly matter in the case of France, although the ECB retains a degree of discretion in its assessment.

We think the bar for the ECB to actively intervene is high, however. By comparison, when the ECB intervened directly in Italian government bonds under the Securities Markets Programme in 2011, 10-year BTP-Bund spreads had moved beyond 500bp.

French bond spreads are already wider than fundamentals alone would imply Source: Refinitiv, rating agencies, ING

"> Germany hides in a temporary safe haven from the“Bad”

Germany sits at the opposite end of the spread spectrum from France. Bunds have reasserted their traditional role as a safe haven during the turmoil in French government bonds. During the geopolitical tensions at the start of the Iran conflict, evidence of such safe-haven demand had been fleeting. This time, the richness of Bunds looks more persistent because the turmoil goes to the heart of some of the monetary union's longstanding vulnerabilities.

Yet the structural forces that had previously driven the cheapening of German government bonds have not disappeared.

Bond supply is likely to increase again as the government continues to roll out its investment and defence spending agenda. The German Finance Agency's funding head has indicated that gross bond funding could exceed €400bn next year, around €50bn more than this year and making Germany the largest issuer of the union. Higher redemptions mean that the increase in net issuance is likely to be only around half as large. But the market must also absorb the German government bonds running off the ECB's balance sheet. We estimate that this could add at least another €80bn to the amount the private sector needs to absorb over the coming year.

At the same time, political instability threatens the government's reform agenda precisely when Germany needs to reset its economic model. An already fragile governing coalition will face five state elections, four of them concentrated in April and May and the other in September.

Once the immediate flight-to-quality premium fades, we expect 10-year Bunds to cheapen back to at least 20bp over OIS, from around 13bp currently. Domestic fiscal and political factors could push the spread wider still by the end of the year.

10y Bund safe haven dynamics outweigh structural issues for now Source: Refinitiv, ING

"> 2027, likely a showdown in two parts

The first half of next year will still be dominated by eurozone political risk. France's 2027 budget might offer temporary but welcome relief at the start of the year, when an important funding window traditionally opens for many issuers beyond the government bond market.

The second half of the year may offer relief from the turmoil, largely contingent on the outcome of the French elections and whether a new president can offer a credible path towards fiscal consolidation. But at that point, Germany, as a core issuer, becomes exposed again to its domestic structural cheapening factors.

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