France's bond market is in trouble. Here's what Australian investors need to know

The latest market at the centre of traders’ collective concerns is France. It’s not exactly a new development – 10-year bond yields have been rising steadily since a dip in late 2023 – but a 125bp increase in a little over three months has brought the issue to the fore.

“When one market reprices, investors reassess similar exposures elsewhere, so we’ve seen spillover into Italy, Belgium, Spain and Portugal. A large share of French debt is held offshore, and foreign investors tend to cut exposure across similar markets at the same time,” Wood says.

“That said, this is so far a sovereign bond story rather than a financial system story. Bank funding markets are calm, there’s no sign of capital flight, and French debt auctions are still well supported.”

According to recent Macquarie sales desk note, the recent surge in yield and the widening of the spread between French and German bonds to 140bp is a reflection of a wide range of factors, including “current difficulties in reducing the deficit, the risk of an ongoing lack of fiscal discipline following the April 2027 election and the impact of rising yields on future budget interest expenses”.

What’s driving the sell-off?

Earlier this month, AMP chief economist Shane Oliver called the conditions facing bond markets a “perfect storm”.

“High energy prices adding to inflation worries; rising expectations for central bank rate hikes; stronger economic data adding to concerns that maybe the neutral short term rate has moved up; worries about big budget deficits in the US, UK, France and elsewhere; increased corporate borrowing to fund data centre investment; erratic US policy marking; and a rising trend in Japanese bond yields leading to a reversal of the so-called carry trade,” Oliver said.

Part of the sell-off can be explained as these global conditions dragging French bond yields higher, but the domestic fiscal backdrop is certainly playing its part as decades of deficits are taking their toll.

“French general government budget deficits have exceeded the EU's 3% threshold under its excessive deficit procedure for most of the past 30 years. Deficits in France have also been consistently larger than the euro area average since the early 2000s,” Macquarie explains.

The country’s debt-to-GDP ratio has risen from around 65% prior to the global financial crisis to almost 120% today – for context, Australia is at around 32% and the US is roughly 125%. Despite being placed in the excessive deficit procedure, France’s budget position has continued to deteriorate, “suggesting no success from these programs in achieving fiscal discipline”.

Schroders’ Wood adds that a major factor driving the bond sell-off is that France entered this global shock with the “weakest fiscal starting point of the large euro economies, and markets have noticed”.

“The government is still running a deficit of around 5.4% of GDP this year and is only aiming for 5% next year. That isn’t enough to stop debt rising. Layer on a divided parliament, a contested 2027 budget and a presidential election next spring, and investors are demanding a bigger risk premium,” she says.

“The trigger was global: the energy shock, higher inflation and tighter monetary policy pushed yields up everywhere. France just had the least room to absorb it. Positioning and the unwinding of leveraged trades have made the moves sharper than fundamentals alone would justify.”

As Wood notes, the most recent budget proposal has attempted to rein in the spending but is still well beyond the EU’s 3% target. Despite this it has sparked protests across the country from students and trade unions.

Even more significant is the April 2027 presidential election, with the two top candidates both sparking concern in markets with their budget commentary. Far-right French National Rally leader Marine Le Pen has pledged to bring the deficit below 3% by 2030.

“However, there is scepticism this will be achieved given the plans to cut immigration and to reduce the legal retirement age back to 62 from 64,” Macquarie adds.

Far-left counterpart Jean-Luc Mélenchon, on the other hand, has instead proposed to have the ECB cancel a large tranche of France’s national debt. Essentially, he wants to take the 18% held by the Bank of France (around €600 billion) and “chuck it in the fire”. Considering the ECB says that wouldn’t be “legally, technically, financially” possible, it’s not exactly easing concerns.

ECB not likely to act

The question now circulating in fixed income markets is whether the European Central Bank will step in to contain the damage, however unless “the rout became sufficiently severe”, Macquarie believes intervention is unlikely.

“Ahead of the ECB's debt crisis bond purchases in May 2010, bond spreads in Greece (650bp), Portugal (400bp) and Ireland (250bp) were trading well above current levels in France. Also, the ECB did not intervene when Greek and Italian bonds spreads were much higher (around 250-300bp) in 2022,” Macquarie says.

“There were signs that monetary policy transmission (e.g. mortgage and business loan rates) had become a problem in the European debt crisis. This is not the case for France as yet.”

For Wood, the issue facing France is "less about the size of its debt than the direction of travel". 

"Many of its neighbours have narrowed their deficits since the pandemic, while France has struggled to make progress, largely for political reasons. Importantly, this isn’t 2011. French banks are well capitalised and hold relatively little of their own government’s debt," she says.

"Europe also has much stronger backstops now. Countries with sizeable deficits, high foreign ownership of their debt or fragile politics are the ones to watch. Belgium is an obvious example in Europe. More broadly, the same ‘fiscal risk’ lens is being applied to the UK and the US."

What does this mean for Australian investors?

As has been the case with most of the other bond market development in recent months, the direct impact of French bond yields surging is going to be relatively small for most Australian portfolios, according to Wood. But that doesn't mean you should ignore it.

"The bigger issue is the indirect channel. If investors are repricing fiscal risk globally, that can push up long-term borrowing costs everywhere, including here. Australia’s relatively strong public balance sheet is a point of differentiation if global investors become more discerning about sovereign credit.

"In the near term, the key risks are the ratings reviews from Moody’s on 23 October and S&P on 27 November, whether the 2027 budget gets through parliament, and the election campaign. The tail risk is a feedback loop where higher borrowing costs slow the economy and worsen the deficit."

There are, however, also opportunities that investors can pounce on, with Wood explaining that much of the political risk has already been priced in.

"If the budget passes and the main parties commit credibly to consolidation, there’s scope for French spreads to narrow. Some of the markets caught up in the contagion have stronger fundamentals than their recent price moves suggest. Higher yields also give long-term investors a better entry point than they’ve had for some time."