Wednesday 29 August 2012

France - Playing the nonchalance - OAT / Bund Yield Spread Widener

"Common sense is not so common." - Voltaire

"nonchalance - the trait of remaining calm and seeming not to care; a casual lack of concern." - Collins Thesaurus of the English Language

Following on our April conversation "France's Grand Illusion", where we pointed with the help of our friends at Rcube Global Macro Research that France was at some point going to face a "rude awakening", due to its structural issues, this time around, we would like to focus our attention to French 10 year government spread versus German 10 year government courtesy of our friends from Rcube Global Macro Research.

In our conversation "A Deficit Target Too Far" from the 18th of April, we argued: "We also believe France should be seen as the new barometer of Euro Risk with the upcoming first round of the presidential elections. Whoever is elected, Sarkozy or Hollande, both ambition to bring back the budget deficit to 3% in 2013 similar to their Spanish neighbor. We think it is as well "A Deficit Target Too Far" on the basis of our previous French conversation (France's "Grand Illusion").

OAT / Bund Yield Spread Widener - Guest post - Rcube Global Macro Research:

"We have been waiting for the right time to sell French OATs for a while. We believe that we are getting close to absolute and relative levels that offer such an opportunity.
Indeed, we consider that the massive rally in French bonds has been mostly due to technical factors rather than fundamental ones.
French financial firms have been repatriating assets from PIIGS countries and buying OATs in the process, which has given the impression that French debt was again considered as a safe haven, just like Bunds.
Additionally, the liquidity associated with French sovereign bonds (due to their fungibility), has made them more attractive for global investors.
Moreover, the French debt is still rated AAA by two major rating agencies (Moody’s and Fitch). While this has also certainly helped OATs on a relative basis so far, we are doubtful that it will keep the highest rating going forward.
This tailwind should slowly fade away.
While it is hard to know if these technical factors have now run their course, we believe that at current levels, French bond spreads vs. Bunds are misaligned with their underlying fundamentals:

An additional issue specific to France is the size of its private sector financing gap, which is among the highest.

According to the INSEE, the debt to value added ratio of French non‐financial corporate business has spiked since 2008 from 110% to 135%. The combined effect of a weaker activity and rigid labor laws forces French corporates to borrow to cover their operating expenses. In this context, it’s difficult to see a robust corporate investment, which implies a weaker growth potential for France ahead.
On a more structural basis, France has always been somewhere between Southern and Northern Europe (between olive oil and butter, wine and beer, the Mediterranean and the Northern sea etc.). To illustrate this, we can notice that the concepts of “PIIGS” and the newly coined “FANG”(Finland, Austria, Netherlands, Germany) now classify Europe in two opposite groups, and that France isn’t part of either group (nor is Belgium, another hybrid country).
Therefore, the perception of France is fluctuating between Germany and Mediterranean countries, as shown in the following graph:

Right before the presidential elections, we kept hearing scenarios (especially from French observers) according to which France would surely join the PIIGS in case of a socialist victory.
Now, 100 days after Hollande’s election (which marked a local top for French spreads), this skepticism has all but disappeared. However, we are comfortable with the idea that the perception of France will continue to fluctuate.
Hollande didn’t make extravagant promises during the campaign (not being Sarkozy was enough to win the elections). However, he will now have to face tough choices: according to the the “Cour des Comptes”, the French government will have to find savings and new taxes totaling €33 Billion
in 2013 to reduce its deficits to 3% of GDP.
Further pressuring the few remaining rich will obviously not be enough to reach this goal, and we are doubtful that socialists were given a mandate to make deep budget cuts during the last elections.
We therefore believe that there could also be disappointment ahead for the French fiscal balance.

Although we believe in the medium term widening of the OAT/Bund yield spread, we currently lack a clear catalyst for entering the trade now."
Rcube's target level for entering the trade via OAT and Bund Futures, is 52 bps on the difference between Bloomberg generic indices GFRN10 Index and GDBR10 Index.

"In general, the art of government consists of taking as much money as possible from one class of citizens to give to another" - Voltaire

Stay tuned!

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