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The yield gap between French and German two-year debt has blown out to its highest level since the eurozone crisis as investors snap up German assets ahead of France’s presidential elections in three weeks’ time.

The two-year spread – a measure of the premium investors demand to hold French over German debt – has hit 47 basis points (0.47 percentage points), surpassing the 42bps reached during the height of jitters about Marine Le Pen’s chance of victory in France’s presidential elections and the widest since the bloc’s debt crisis abated five years ago (see chart above).

The spread has swollen from 26bps just 10 days ago, a move that stands apart from a narrowing in the 10-year spread – usually considered a more traditional barometer of stress in the government bond market. France’s benchmark spread with Bunds has fallen back from a peak of nearly 80bps in February to around 66bps.

Yields on Germany’s two-year “Schatz” bond have been driven to record negative lows as the European Central Bank has begun buying the debt this year as part of its landmark stimulus measures (yields fall when a bond’s price rises).

Meanwhile, French two-year yields have doubled from lows of 0.6 per cent in the summer of 2016 to around 1.8 per cent in February. French debt fell sharply earlier this year when one-time favourite for the French presidency, François Fillon, was hit by an embezzlement scandal, bolstering the chances of far-right rival Ms Le Pen.

For investors worried about the prospect of Ms Le Pen coming good on her vow to yank France out of the eurozone, moving from French to German two-years looks like a good bet, said Markus Allenspach, head of fixed income at Julius Baer.

“The new parameter [for eurozone bond market stress] is the spread between two-year German bonds and the equivalent French debt”, said Mr Allenspach.

The unprecedented rally in short-term German debt – where yields have plumbed to as low as -0.95 per cent – has also led to head-scratching among senior officials at the European Central Bank.

Benoît Cœuré, one of six executive board members at the ECB, yesterday noted the sharp decoupling between yields on the high-quality German short-dated bonds and market swap rates (more on that from Alphaville’s Izzy Kaminska here).

Among some of the explanations, Mr Cœuré stressed the role of non-eurozone investors in driving up prices for prized German bonds in a world where the ECB has cut its deposit rate below zero.

“[Non-euro] investors without access to the Eurosystem’s deposit facility are typically forced to park excess liquidity in the most liquid and safest available storage facility, most often in bonds issued by the safest sovereigns”, said the French central banker in a speech in Paris.

Data from the ECB shows overseas investors account for 90 per cent of the short-term German debt markets – up from 70 per cent two years ago when the central bank began its stimulus programme (see below).

Other factors ramping up demand for short-dated debt include regulatory changes since the financial crisis, investors’ “haven” trades in times of political uncertainty, and a general dearth of safe assets.

“We see growing demand chasing declining supply”, said Mr Cœuré, adding that governments across the eurozone have moved to issue more longer dated debt to lock in historically low borrowing costs.

Copyright The Financial Times Limited 2017. All rights reserved.
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