France: Short The OAT And Mind The Euro

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Includes: DEUR, DRR, ERO, EUFX, EUO, FXE, UEUR, ULE, URR
by: Rothko Research
Summary

Over the past two decades, one of the main economic issues in France has been the very high level of the structural rate of unemployment.

The ‘Yellow vest’ protests against President Macron’s economic agenda have halved economic growth expectations for the next few quarters, rising pressure on the government budget.

Our leading economic indicator is clearly not showing any signs of recovery within the next 6 months to come and is pricing in further deterioration in the industrial production.

Hence, with the 10Y OAT currently trading at 35bps, we think that being short French bonds could an interesting trade for the time being.

In addition, widening spreads could weigh on the euro in the coming months.

Over the past two decades, one of the main economic issues in France has been the very high level of the structural rate of unemployment. Figure 1 (left frame) shows that while the unemployment rate in the Euro area fell from 12.1% in June 2013 to 7.8 % in February in the Euro area, it fell by only 1.6% to 8.8% in France during the same period. In other words, the volatility of the unemployment rate in France has been much lower than in other Euro area countries.

Despite the ECB stimulus, which has increased the central bank’s balance sheet by EUR 2.6tr since the third quarter of 2014 up to EUR 4.7tr, the jobless rate has not decreased that much and therefore makes Macron’s 2022 7-target unachievable. Figure 1 (right frame) is referring to the unemployment rate for youth (15-24); according to the OECD, youth unemployment rate stands at almost 20%, which is 3.5% higher than the Euro area one and almost 8% above the average of the OECD countries. As opposed to the US or many other OECD countries, the employment rate of young people is much lower as higher education is mostly free and students can also get stipends from the government. As a result, the employment rate for youth is only 30%, versus 50% in the UK and the US.

Figure 1

Source: Eikon Reuters, OECD

In addition, the ‘Yellow vest’ protests against President Macron’s economic agenda, which have been on-going for the past 26 weeks, have halved economic growth expectations for the next few quarters, rising pressure on the government budget. Our leading economic indicator, which is computed as a linear combination of price data and surveys, is clearly not showing any signs of recovery within the next 6 months to come and is pricing in further deterioration in the industrial production (figure 2, left frame). France managed to shrink its government budget below the Stability and Growth Pact limit of 3% (of the country’s GDP) in the past two years, to 2.8% and 2.5% for the year 2017 and 2018, respectively. However, the government already announced earlier this year that the deficit will increase to 3.2% in 2019 following Macron’s €11bn package to boost low incomes and maybe even bigger if the uncertainty around growth expectations persists in the medium term. This will clearly question the nation’s debt sustainability (once again) and may generate some price volatility in some of the French asset classes. Figure 2 (right frame) shows that France remains the only core country where the debt-to-GDP ratio has continued to increase since 2014; while the debt-to-GDP ratio decreased from 91.9% in 2014 to 86% in 2018 in the Euro area, it increased from 94.9% to 98.7% in France (it has even stabilized in Italy).

Figure 2

Source: Eikon Reuters, RR

As a consequence, we think that pressure on long-term yields could start to rise in the coming months if the current economic environment persists. Even though the lack of excess liquidity in the Euro area would suggest us to hedge or take a short position on risky assets such as equities (figure 3, left frame, shows that excess liquidity tends to lead cyclical stocks such as financials), we think that being short French bonds could be a more advantageous trade. The persistence of the economic uncertainty will eventually push non-resident holders (NRH) of French securities to sell their bonds and therefore rise the term premium. With the 10Y OAT currently trading at 35bps, we would feel more confident in being short French bonds than German bonds even though the 10Y Bund trades at -5bps. Figure 3 (right frame) shows that in the last cycle, France LT yields can rise significantly relative to German ones; the OAT-Bund has averaged 45bps but rose to 160bps during the eurozone crisis and 75bps prior to the French elections, respectively.

Figure 3

Source: Eikon Reuters, RR

We saw previously that a sudden rise in the 10Y France-German spread tends to have a negative impact on the euro; figure 4 (left frame) shows that when the spread widened from 22bps to 75bps in the 6 months preceding the French elections, the euro plummeted by nearly 10 figures to 1.0450 against the US dollar. This adds up to our previous analysis that the single currency remains vulnerable in the short run despite its cheap valuation (PPP prices a ‘fair' value at 1.37). After breaking its 6M support at 1.1185, EURUSD is back above 1.12 but still remains under pressure. The momentum looks clearly bearish for the time being and therefore any sudden euro strength could be considered as a good opportunity to short the pair.

Figure 4

Source: Eikon Reuters

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in EURUSD over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.