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French election nerves are back with a bang in the bond markets

With just two weeks to go before the country’s hotly contested first round presidential vote, investors are demanding a steadily rising premium to hold the country’s 10-year bonds over the equivalent “safe” German assets.

Having calmed over March, France’s 10-year yield gap with Bunds is now back up to 75 basis points, just shy of the four-year peak of 77bps hit in late February when the race heated up following embezzlement allegations against right-wing candidate François Fillon.

The two-year bond spread has also blown out to its widest level since the eurozone crisis, as investors flee French short-term debt for German “schatz” as one of the best hedges against political risk in the eurozone’s second largest economy (more on that here).

The most recent widening in spreads has coincided with polling showing an upsurge in support for far-left firebrand and ex-Socialist party member Jean-Luc Mélenchon.

Having promised to “soak the rich” with income taxes and pushed for the European Central Bank to monetize the debts of the southern Mediterranean, Mr Mélenchon’s popularity has risen following a series of impressive performances in the country’s televised presidential debates.

His success, alongside the far-right Marine Le Pen who is polling joint first, underscores the polarised political debate in the country after five years of Socialist party rule. Both candidates have also adopted a decidedly cool stance on the EU: while Ms Le Pen wants a referendum to pull France out of the euro, her far-left rival is pushing for sweeping overhauls of the EU’s treaties.

A poll from Kantar Sofres yesterday showed a six point swing toward Mr Mélenchon this week, putting him in third place after the Front National Leader and centrist favourite for the Élysée palace, Emmanuel Macron.

With momentum behind him, analysts at Nomura expect the 65-year old – who is promising to set up the “Sixth Republic” – could end up polling over 20 per cent on April 23rd.

“It is precisely such erratic headline risk that has prompted our repeated message that although France has cheapened on various [bond] metrics, we wouldn’t buy the dip just yet”, warns Peter Goves, credit strategist at Citi.

Should the far-right and far-left anti-establishment candidates make a good showing in the first round, Francesco Garzarelli at Goldman Sachs thinks the yield gap has further to go.

Even without a fresh turn in the French presidential race, rising US yields are likely to drag most of the eurozone’s bond markets up with them, adds Mr Garzarelli.

Jordan Rochester at Nomura adds: “If Jean-Luc Mélenchon were to face Marine Le Pen, we would enter an outright short French bond position, likely in the 3-5 year part of the curve”, said

And having been burnt by a turbulent 2016, Sam Hill at RBC Capital Markets thinks nervy investors are not willing to get singed again:

Against the backdrop of Brexit and US election results last year, a potential strong showing of anti-establishment parties in French elections is likely to make some investors uncomfortable with higher risk assets.

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