Yellow Vest contagion: do the bond markets care?

With the Yellow Vest protests, the risk premium of French governments over their German peers is now the widest it has been since the run-up to the presidential election in April/May last year. The spread reflects both the heightened political risk, as well as concerns about the fiscal implications of the proposed policy response—especially the promised tax cuts/freezes and the minimum wage rises. There is growing unease that the latter could set a dangerous precedent for other EU countries, which may also consider expanding their budgets and challenging European Commission rules. Ultimately, this could lead to wider spreads across the Eurozone and further exacerbate tensions within the bloc.

In our recent blog post on stress testing Italian contagion risk, we noted that other peripheral issuers seemed to have been largely unaffected by the spread-widening of Italian BTPs. Even though the risk premium of Spanish 10-year Bonos over same-maturity German Bunds has risen around 50 basis points since the Italian coalition talks in mid-May, the move was dwarfed by the 150-basis point surge in the BTP-Bund spread. In contrast, the yield difference for 10-year OATs has widened only 8 basis points since the start of the Yellow Vest demonstrations on Nov. 17.

More recent asset-class and risk-factor correlations do not yet indicate that markets are overly concerned about contagion of credit-spread increases. It appears that traders still distinguish between countries with the very high debt-to-GDP ratios, such as Italy (132%), Portugal (123%) and Greece (180%), and those with levels below 100%, such as France (96%) and Spain (97%). There is, however, an increased risk of wider spreads—and ultimately contagion—once the European Central Bank removes an important support for European bond markets by terminating its asset purchasing programme in January 2019.

The euro was also affected by the political unrest. In the first week-and-a-half after the start of the protests, the common currency lost about 1.5% against the US dollar. Since then, it has regained some of the losses, as the dollar depreciated on renewed trade war fears. In contrast, for example, the British pound—which lately has been driven by the status of the Brexit negotiations—the factors that drive the euro are more complex and manifold. As the second-biggest reserve currency in the world, the value of the euro can be expected to be influenced by considerations outside the Eurozone, such as the escalating trade conflict between China and the US.

Another peculiarity of the euro is that it is shared by 19 countries. This means that Eurozone members, such as France and Italy, do not have the ‘release valve’ of their own currencies. Therefore, any increased political uncertainty will be reflected in the yield premium of their bonds over the risk-free benchmark—in this case, German Bunds—rather than the exchange rate.

So far, this risk barometer only indicates moderate concerns. Similar to what we noted in our recent blog post about the France’s equity risk, the heightened uncertainty is rather reflected in an increased demand for safer government bonds and a slight depreciation in the common currency.

Christoph Schon, CFA, CIPM

Christoph Schon is the Executive Director, Applied Research for EMEA at Axioma, where he generates insights into recent risk trends with a particular focus on fixed income and multi-asset class analysis. Christoph has been in the portfolio risk and performance analysis space for more than 10 years, having previously worked for Lehman Brothers/Barclays POINT and UBS Delta.