Prior to the French election, the market has sounded a "red alert" as the spread between French and German government bond yields has returned to high levels reminiscent of the eurozone debt crisis.

Despite the fact that the French presidential election is still eight months away, signs of pressure are already emerging on the country's assets. As one of the most closely watched indicators of bond risk, the borrowing cost premium for France relative to Germany has nearly reached its highest level since the 2012 European sovereign debt crisis. Tensions have also spread to the French stock market and corporate bond market, dragging their performance down compared to international counterparts. For investors, the core issue lies in how the next president, who will succeed the business-friendly centrist Emmanuel Macron, will address deep-seated economic challengessuch as a fiscal deficit exceeding 5%, soaring debt repayment costs, and weak growth bordering on recession. Both far-right candidate Marine Le Pen and far-left candidate Jean-Luc Mlenchon have pledged to take France in vastly different directions. The proposals put forward by these candidates (who just participated in their first campaign debate last week) include stimulating the economy by increasing spending, lowering the retirement age, cancelling part of the government debt, and even halting financial contributions to the European Union. The following are several aspects reflecting the rising political risk in France that have already manifested in the market. Bond Market Bond futures trading data shows that investors have established new short positions, betting on a decline in French bond prices. "There is neither a parliamentary majority, nor room for budget maneuvering, and political capital is entirely consumedMacron clearly lacks the power to stop the situation from deteriorating," said Louis-Vincent Gave, CEO of Gavekal Research, regarding French bonds. "On the contrary, the risk is that the situation may deteriorate at an accelerated pace." How to address France's mountain of debt has dominated recent debates. Although the current government has attempted to reduce the deficit, its fiscal goals have repeatedly been undermined by a fragmented parliament. For long-term investors, the 15-year forward rate starting 15 years from now can exclude the short-term impact of monetary policy, serving as a measure of long-term borrowing costs. Currently, the interest rate spread between France and Germany for this indicator has approached its highest level since 2012, indicating the market is pricing in a structurally worsening fiscal situation for France relative to Germany over the coming decades. Stock Market In terms of stocks, local revenue from the French benchmark CAC 40 index component companies accounts for less than 20%, which somewhat limits the impact of political risk on earnings. However, sectors predominantly driven by domestic demand, such as banking, utilities, telecommunications, and construction, often face pressure due to widening French-German bond spreads. Wider spreads reduce the attractiveness of French stocks, inhibit corporate investment capacity, and ultimately harm competitiveness. Goldman Sachs has compiled a basket of stocks with high exposure to France's sales, including BNP Paribas, Orange, Engie, and Vinci. This index fell over 3% last week due to rising political uncertainty, underperforming the pan-European Stoxx 600 index, which rose 0.2% during the same period. Analysis from Barclays found that the risk premium already reflected in French blue-chip stocks is close to the phase-highs observed during previous election cycles. Their calculations are based on the difference in forward volatility between the CAC 40 and the S&P 500 indices for March/June. "This indicates that while election premiums may continue to accumulate, the current pricing already accounts for a considerable degree of political uncertainty," strategists including Stefano Pascale and Anshul Gupta wrote in their report. Their research also showed that Air Liquide, AXA, and Renault have the highest historical sensitivity to changes in the spread between French and German bonds, which means these stocks could be particularly vulnerable should the sovereign risk premium widen further. Credit Market Bonds issued by French financial institutions have shown signs of fatigue, with risk premiums rising more than the overall level in the eurozone bank bond market over the past month. This divergence is especially pronounced in bonds maturing within five years, while the long-end spread has narrowed. The worst performers have been subordinated debtthese bonds take the first losses when banks fail. During previous periods of high political risk in France, the banking sector has consistently been one of the most volatile industries in the credit market. In 2024, Macron's announcement of an early election led to a surge in trading volumes for bonds issued by large French banks. Currency Risk Indicators measuring the risk of France exiting the eurozone are rising, but still remain below the peaks of the past two years. This metric is derived from the spreads between different credit default swaps and is currently far below the levels seen during the 2017 election, when Le Pen threatened a referendum on abandoning the common currency. However, the leading candidate in recent polls, Le Pen, has abandoned this position. Nonetheless, this spread remains noteworthy, as it could serve as a leading indicator of potential tensions in the relationship between France and the European Union in the coming years. Leftist politician Mlenchon, considered Le Pen's main rival, has proposed that France could choose not to comply with EU rules and treaties when they conflict with French interests.