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Spain vs. France: A lesson in perception, from bonds

Fire fighters try to control the fire inside a trash container during a protest against austerity measures announced by the Spanish government in Madrid, Spain, on Thursday July 19, 2012.Tens of thousands of angry Spaniards protested in 80 cities throughout Spain on Thursday against the government's latest austerity package, blaming officials for "ruining" the country.

Andres Kudacki/AP

One indebted country has pushed through unprecedented austerity measures and persuaded Europe to shore up its banks. The other has done very little and is about to roll back even some of that.

Which one is paying near zero per cent on its debt?

Spanish Prime Minister Mariano Rajoy must be wondering what he needs to do to get his country's borrowing costs down from levels that, over time, will bankrupt it.

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Just to the north, French President Francois Hollande, whose country is financially in only slightly better shape, could be forgiven for thinking financial markets were mistaking France for Germany.

No matter what policy steps euro zone countries are taking –individually or as a whole – the gap between the economies in the north and those in the south are growing wider, the opposite of what European leaders are trying to achieve.

"Investors are drawing a dividing line along the Alps and the Pyrenees," Rabobank rate strategist Richard McGuire said about the paradox of two debtors being treated as if they belonged to different worlds.

With 10-year borrowing costs of around 7 per cent, Spain may soon be forced out of capital markets. France, on the other hand, looks like one of the world's safest debt markets, with its debt costs some 500 basis points lower.

On Thursday, investors even got to the point of paying what amounts to a parking fee – a negative yield – on short-term French debt.

This contrasts with the picture in November last year when France was seen as the next weakest link in the euro zone after Spain and Italy and the spread, or difference, between French and Spanish 10-year yields was about half what it is now.

There are a multitude of reasons for this unequal treatment on bond markets – France's slightly stronger economy, its history of being close to Germany politically, and recent moves by the European Central Bank.

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But for the moment and perhaps unwarranted, France is basking in the euro zone's core and Spain is being hung out to dry.


There is an awkward feeling about the flows into French bonds, though. Investors' view that France is the weakest of the so-called "core" group of the euro zone has not changed.

France has plenty of things to put investors off. A stubbornly high budget deficit, a flagging economy, still strong financial ties with Italy and Spain and inflexible labour markets are only a few.

While Mr. Hollande has managed to keep this year's budget deficit target of 4.5 per cent of economic output on track by raising taxes on the rich, he is yet to deliver the deep structural reforms that markets were pushing for in November.

While most countries in the euro zone are lifting the retirement age, he has cut it. But he still needs to find a massive €33-billion worth of savings for next year.

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That none of this is weighing much on French bonds is mainly because investors are being driven to find yield, or return for their money, wherever they can.

Germany – the bloc's last domino – has little room to accommodate more money in its debt markets, so many investors are simply forced to ignore France's shortcomings and boldly expand the area where they choose to deploy their cash.

"France is not doing great in terms of budget deficit progress and other reforms but you need at least some yield and German paper is not going to do the trick," Commerzbank rate strategist David Schnautz said.

"Buying France is the lesser of two evils."

A key factor has also been the European Central Bank's unconventional policy.

First, the injection of almost €1-trillion in three-year loans into the euro banking system renewed demand for Italian and Spanish bonds from their domestic banking sectors in the first part of this year.

While banks in Spain and Italy bought more risky debt from their shaken sovereigns, French banks were among those selling it to them, boosting the health of their balance sheets.

Also, two weeks ago, the ECB cut the rate it charges banks for depositing cash with it overnight to zero, doing little to quell underlying concerns about Spain, but effectively taking out what was previously seen as a floor for bond yields and other euro zone interest rates.

As well as Thursday's French bills, yields on short-dated bills issued by the bloc's safest economies – Germany, the Netherlands and Finland – have recently turned negative.

So, in a hunting for yield, many are now buying French bonds, which are perceived as riskier, but at least offer a bit higher returns.

Ten-year French yields trade at record lows just above 2 per cent, some 80 basis points over their equivalent in Germany.

"It feels different compared to the end of last year when we saw clients excluding France from their benchmarks," said Kommer von Trigt, a bond fund manager at Robeco, a firm managing assets worth €177-billion.

"There is a new catalyst now, which is the ECB."


At the other end of the spectrum, investor perception that the euro zone's southern periphery is at least potentially in danger of breaking off, is hammering Spain.

"Euro zone without France is something that people really have to struggle with," Commerzbank's Schnautz said. "You can imagine a lot of things but there's basically a point where imagination turns into fantasy."

Despite this, some investors say the French bond rally is a distortion caused by the ECB's loose monetary conditions, which could prove to be transient if the euro zone debt crisis advances further.

Rabbani Wahhab, senior fixed income portfolio manager at London and Capital, a $3.2-billion fund, "deliberately" stays away from France and the peripheral markets.

"Our fear for the French bonds is that they will be once again caught in the crossfire when ... things blow out again in the periphery."

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