Comment: Ignore the French elections at your peril

Eurozone peripheral bond markets are currently enjoying a liquidity binge and remain focused on the new three-year LTRO at the end of the month. But the French election later in the year is something to worry about.

Markets underestimate the game-changing nature of the French elections, as they impact on the Franco/German axis which during the crisis has become dominated by views, opinions and demands from Germany.

Merkel uncomfortable without Sarkozy

What has become clear is that German Chancellor Merkel is uncomfortable with the prospect that an ally in the form of French President Sarkozy will likely be unseated at the French elections to be held on April 22 (first round) and May 6 (second round). This has seen Merkel take the surprising move of directly campaigning for the re-election of Sarkozy, suggesting Merkel is more popular than Sarkozy in France.

Standard & Poor’s decision to move France from being rated Triple A has highlighted the growing divergence between France and other core countries and in particular Germany. Worried that sticking with Sarkozy will only lead to a widening of this gulf, voters see Socialist Party candidate Francois Hollande – Sarkozy’s rival and the frontrunner – as providing a different script and maybe a way to rebalance the Franco/German axis.

Hollande wants to also pursue deficit reduction through a mix of increasing government spending and higher taxes, reversing the increase in the retirement age from 60 to 62, and providing a greater focus on pro-growth and pro-employment policies. Renegotiation of the fiscal compact which was agreed at the December EU summit is also an important plank of his policy objective. In addition, Hollande is in favour of Eurobonds, wants a more active ECB, and a well-resourced bailout fund, all of which Sarkozy, despite being in favour of, had chosen to allow Germany to dominate the discussions.

Hollande a risk to Franco-German cohesion?

A victory for Hollande would clearly risk opening up old debates which had been considered to have been put to rest, and could lead to a rift between France and Germany. Acceptance from Germany in bailing out Greece, Portugal and Ireland as well as boosting the EFSF firewall have all come on the back of a quid-pro-quo of structural reforms, fiscal austerity, and fiscal integration. If a new leader in France looks to take a step back, then the German bailout/firewall cheque book, while not completely blank, will likely make less of an appearance or even be completely shut.

It will be difficult for Merkel to play an active role in crisis prevention under a new French President. This is especially as Merkel herself will face German voters’ wrath next year during national elections sometime between September 1 and October 27. Once the ECB-induced liquidity party is over, attention will turn to the implications of the French elections. The risks suggest we will then see higher peripheral yields, wider spreads and flatter curves.

Market implications beyond the February three-year LTRO

For those holding peripheral exposure, the time until the three-year LTRO at the end of the month should be used to lighten the portfolio of risk, especially on Portugal and Ireland. For Italy and Spain we still like 2/10-year curve flatteners, but entering and holding on to this trade has proved to be difficult.

Given that France will be in the spotlight, we would continue to hold 10-year France/Germany spread widening trade as French election risk and the prospect of fiscal slippage will need to be priced.