The French Bond Market Is on Fire

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1:12There's also LVMH or Sanofi, or, according to the credit strategists at Barclays, a fairly wide selection of BBB-rated companies. the bottom rung of what the rating agencies call investment grade. All of them can now borrow money more cheaply than France. So can Italy and so can Greece, which is a bit embarrassing, as French officials have spent the last four nights reassuring everyone that France is not Greece. Bloomberg calculates that about 215 billion euros of French high-grade corporate bonds, or 38 % of the market, now trade at lower yields than French government debt of a similar maturity.

1:56At the start of the year, it was just 12 billion euros. Now, in theory, a government is the safest borrower in its own country. If things go wrong, it can always raise taxes or print more money. L 'Oreal can't do either of those things. It is no legal way of sending armed police to your house to collect 70 euros for moisturizer. France, as it happens, can't print money either. It handed that job over to the European Central Bank in 1999, which we'll come back to later. But it can still raise taxes, so investors have always given it the benefit of the doubt. Over the last few weeks, they've been rethinking that.

2:41French 10-year borrowing costs came within a whisker of 5 % last week, the highest rate in almost a quarter of a century. The spread over German bonds, which is how bond traders measure how nervous they are about a country, briefly topped 1.5 percentage points, the widest it has been since 2011. In Eurozone seating plan terms, France has been moved from the top table to the one near the bathroom. While this has been going on, high school students across France have spent the last few weeks blockading their schools in protest at teacher shortages, overcrowded classrooms and buildings that are falling apart.

3:23Most of the marches have been peaceful, but some have not. A few entrance halls have been set on fire and more than 6 ,000 people have been arrested, most of them teenagers. Setting fire to your school in protest at the condition of school buildings is a bold negotiating strategy, though I suppose it does strengthen the case for renovation. The students would like more money spent on schools. The bond market would like less money spent on everything. The French government is standing in between them, holding a budget. During the Euro crisis, the bond market's troublemakers travelled as a group, the PIGS, which were Portugal, Ireland, Italy, Greece and Spain.

4:11This time, as Lionel Laurent pointed out in Bloomberg this week, France has been given an acronym all its own, FROGS, which stands for French Oversized Government and Social Security. It was coined by a Paris research firm called Rexicode, so at least the insult was made in France. I think it is okay if they say it themselves. I am not sure if I am allowed to say it. I will credit Rexicode every time just to be safe. As an Irishman, I of course take a strong interest in this sort of thing, as I helped to put the eye in pigs, or my country did anyhow. I mostly just watched the bond deals. So I'd like to formally welcome France to the club.

4:57The membership fee is about 10 years of austerity and the Troika will soon be in touch.

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5:30Patrick Boyle: Does checking your bank statements feel like digging through a dusty attic full of forgotten subscriptions and old free trials? Experian can help take the pain out of canceling by handling it for you. Think of it as Operation Get Your Sanity Back. Over 200 subscriptions are cancelable. So get started in the Experian app and see how much you could save. Results will vary. Not all subscriptions eligible. Savings not guaranteed. Paid membership with connected payment account required. See Experian.com for details. Experian. So, to understand why the French bond market is on fire, it helps to look at why everyone else's bond market is also smoking slightly.

6:10For most of the last decade, borrowing money was close to free and governments understandably took full advantage of the offer. Today, according to The Economist, the median 10-year government bond in the rich world yields around 4%, the highest in more than 15 years. America's 10-year yield topped 5.3 % this week, and Japan's crossed 3 % for the first time since 1996. There are a few reasons for this. The first is AI. Goldman Sachs expects the five biggest hyperscalers – Alphabet, Amazon, Meta, Microsoft and Oracle to spend around$800 billion on capital investment this year alone, and$1.2 trillion next year, which would be more than 3 % of America's GDP.

7:04At first they paid for their data centers out of their own cash flow, now they are borrowing. They have issued$230 billion of bonds so far this year, which is double last year's total. That money comes out of the same global pool of savings that governments borrow from, and the AI companies are not very price-sensitive borrowers. The FT reports that they see building data centers as an existential necessity, and an extra percentage point or two of interest is just a detail. The Economist says that the hyperscalers now account for nearly 10 % of new Euro-denominated bonds sold by non-financial companies, and that some European firms avoid issuing debt on the same day that they do.

7:54The second reason is the war in Iran. Crude oil is about 40 % more expensive than it was before the war started. This has kept inflation high and pushed central banks into raising rates rather than cutting them. The Federal Reserve raised rates in September for the first time since 2023, and the ECB has raised twice since June. Now, when borrowing costs go up, every indebted government gets tested. The arithmetic goes like this. If your economy grows faster than the interest rate on your debt, the debt shrinks as a share of national income over time, as long as you aren't borrowing too much on top.

8:35If the interest rate is higher than your growth rate, the debt grows relative to the economy, unless you raise taxes or cut spending. Economists call this R-G, which is about as exciting as it sounds. Some countries are getting through the test for now, each for their own reasons. America runs a deficit of about 6 % of GDP, which the economist describes as unsustainable, But it issues the world's reserve currency. Its economy is growing at over 3 % a year, and investors still seem happy to lend to it. Japan's net debt is 134 % of GDP. Its gross debt is a lot higher than that. But inflation has risen alongside interest rates, so in real terms the debt is shrinking and most of it is owed to the Japanese.

9:30Britain's 30-year gilt yield is above 6%, the highest since 1998. But Britain already had its bond market revolt in 2022, when Liz Truss's unfunded tax cuts were outlasted by a lettuce. British politicians have been nervous of the gilt market ever since. And then there's France. It doesn't issue a reserve currency. It isn't having an AI boom. it imports most of its oil and gas, and it hasn't had its Liz Truss moment yet. As The Economist points out, French borrowing costs were about two percentage points above nominal GDP growth in the second quarter, the widest gap in the rich world, and the gap has widened since.

10:17On those numbers, unless something changes, French debt keeps growing faster than the French economy. So, how hard is the arithmetic? Well, back in May, the French government asked four independent economists to work out where the country's public finances were heading. Their report came out in July, and it said that based on current policies, the deficit would rise to 6.8 % of GDP by 2030, that debt would pass 130 % of GDP, and that the interest bill would grow by about 10 billion euros a year. They also noted that the interest bill was already approaching the budget of the entire Ministry of Education, and we'll come back to that in just a moment.

11:06To stabilize the debt, the paper argued that France would need to make savings worth about 125 billion euros a year by 2032. That calculation assumed France's 10-year borrowing rate, which was 3.7 % at the time, would drift down to 3.3 % as the bond market rewarded the government for behaving responsibly. That rate has recently risen to about 4.9%. The report came out in July, which in bond market terms makes it a historical document. Ben Hall at the FT reckons that the amount that needs to be saved per year has already gone up to 140 billion euros. Against that, Prime Minister Sébastien Le Corneux's 2027 budget proposes 43 billion euros of spending cuts and tax rises.

12:01For one year, that's a big number. The problem is that something like that has to happen again and stick every year until 2032. And Le Corneux doesn't have a majority in Parliament. ING's economists say that even if his plan passes in full, it won't stabilize the debt. Part of the problem, according to the Commission, is that the French state has come to see itself as the insurer of last resort for every crisis. When something goes wrong, the state steps in to protect household incomes and company balance sheets, and the emergency measures tend to stay in place long after the emergency has passed.

12:45The report calls this a ratchet effect. In insurance terms, the French state writes a policy for every disaster and never lets one expire. This month, the queue of claimants includes students, farmers, fishermen, truckers, construction companies, and nurses. Normally, a government that spends too much can raise taxes, but France's tax take is already at 44 % of GDP, compared to an OECD average of 34%, and the Commission says that it's the highest in the eurozone. The economists warn that the public's consent to taxation is weakening because people feel that they're paying more and more for public services that are getting worse.

13:31People will put up with Scandinavian tax rates if they get Scandinavian schools. They get less enthusiastic when the roof is leaking. And that leaves the option of spending cuts. Almost a quarter of public spending in France goes on pensions, and French workers retire earlier on more generous terms than in most rich countries. While pensions aren't legally untouchable, they are politically radioactive. Le Corneau's budget proposes freezing the most generous state pensions, and the opposition parties are already lining up against it. Defense spending, meanwhile, is the one area that has been ring-fenced.

14:14Now back to the schools. The protests started in the middle of September at a lycée in Crétiel, just outside Paris, over long school days, crumbling buildings and teacher shortages. The Economist reports that spending per secondary pupil has been flat in real terms for a decade. Two weeks into the protests, the government published its budget, which cuts 1 ,588 teaching posts on the grounds that pupil numbers are falling. As timing goes, that could have been a bit better. One university student summed it up, saying, the budget for the army is increasing, but not for education. A student union reckons that the students' demands would cost about 10 billion euros.

15:03Le Cournot has promised measures that are concrete swift, hence funded, which he'll announce at the end of the month. So, the government is stuck. Every euro it tries to save brings someone new out onto the streets, and every year it doesn't save anything, the interest bill goes up by another 10 billion. Which raises the difficult question, if France is in this much trouble, how is Italy, a country with more debt than France, able to borrow more cheaply? To answer that, we need to go back to our official league table of borrowers that the bond market currently considers safer than the French Republic.

15:45Greece has been on it since the end of 2024. Italy joined last year. Emmanuel Moulin, the governor of the Bank de France, told the FT this week that France is not Greece. Which is true, they are an entirely different country. But Greece does borrow more cheaply. Italy is maybe more of a puzzle. The Economist puts Italy's net debt at almost 130 % of GDP, while France's total debt is just under 120%. Normally, if you owe more than someone else relative to your income, you'd expect to be the one paying the higher interest rate. You might think that the bond market is rewarding Italy for some newfound culture of enthusiastic tax compliance, but that doesn't seem to be the case either.

16:35The FT reported this week that an estimated 60 ,000 cars and motorbikes, mostly in and around Naples, are registered in Poland. Their Italian owners transfer their ownership to Polish shell companies with the promise of saving about 70 % on road tax and insurance. Naples has some of the highest car insurance premiums in Italy, and the road tax on a Fiat Panda is around 130 to 140 euros a year. According to the Polish Car Insurers Agency, most of these vehicles have never been on the roads of Poland. There are other benefits too. Parking tickets and speeding fines get sent to the Shell Company in Poland where, as the same agency puts it, everything vanishes into thin air.

17:24The Italian and Polish police are both aware of this. In March, police in Warsaw arrested seven people for producing registration papers for more than 1 ,500 vehicles, with the help of what investigators described as corrupt local officials. All of the cars had passed Polish technical inspections, which was impressive considering that none of them had ever been to Poland. With an election coming in 2027, Georgia Maloney's government has come up with a solution. It's suspending the road tax on small and mid-sized cars for a year, which will leave about 2.4 billion euros with Italian motorists rather than the Italian treasury.

18:07This is possibly the most effective anti-evasion policy ever devised. It's impossible to dodge a tax that doesn't exist. For now, the hole in the budget will be filled with money left over from Italy's EU-funded COVID recovery plan. Francisco Galletti of the consultancy Policy Sonar described it to the FT as giving some sugar to voters. So Italy is not exactly Switzerland, but it still borrows more cheaply than France. Different governments take different approaches to raising revenue. While France is searching down the back of every sofa in the country for taxable euros, other countries are a bit more relaxed about it.

18:53In 2016, the European Commission ordered Ireland, founding member of the PIGS, to collect 13 billion euros in back taxes from Apple. The Irish government spent the next eight years in the European courts arguing that it didn't want the money, which is a position that would be hard to explain to a French finance minister. Ireland finally lost that case in 2024, and roughly 14 billion euros, including interest, was handed over. Having 14 billion euros deposited in your bank account against your will is a heavy cross to bear, but as an Irishman, I can tell you that we accepted it with great dignity.

19:35So anyhow, back to the bond market. If bond yields were a reward for paying your road tax, Italy would not be beating France. Growth and political stability matter too, of course, but the biggest difference between the two countries comes down to one line in their accounts, the primary balance. The primary balance is a government's budget before interest. You take everything the state collects in taxes, subtract everything it spends on running the country, the schools, the pensions, the hospitals and the army, and you ignore the interest on its debt. Italy runs a primary surplus. It collects more than it spends on everything, if you exclude interest.

20:19And it has done that most years since the early 1990s. It learned the hard way in the 1992 currency crisis and again during the euro crisis, but it learned. Its overall deficit, interest included, is expected to fall below 3 % of GDP this year. France runs a primary deficit of 2.9 % of GDP. So even if France had no debt at all and paid no interest to anyone, it would still be borrowing to keep the lights on. It has run a primary deficit every year since 2002, and it hasn't balanced its overall budget since 1974. Italy has its own risks. It has an election in 2027, it is populace of its own, and its deficit is expected to tick back up next year as it spends more on defence and on cushioning the energy shock.

21:16But the bond market has made a fairly practical calculation. Italy has already had its crisis and has shown that it can run a surplus. France hasn't. And as the past three weeks have shown, the political cost of even talking about an adjustment in France is very high. So, what does the French political class plan to do about all of this? The short answer is, quite a lot, and not all of it adds up. Let's start with the government. Emmanuel Macron came to power in 2017, promising business-friendly reforms that would boost growth and fix public finances. Over his nine years in office, the national debt has grown by more than a trillion euros, a lot of it spent protecting households and businesses from the pandemic and the energy crisis.

22:08Since the 2024 snap election left France with a hung parliament, budget negotiations have cost two prime ministers their jobs. The current one, Sébastien Le Corneux, is trying to pass his 43 billion euro package without a majority and lawmakers are expected to rewrite much of it. Then there's the opposition, which is preparing for next April's presidential election. election. Leading the polls is Marine Le Pen of the National Rally, whose party has long championed generous state spending. On Tuesday, she announced that she is now a champion of fiscal discipline. She wants a constitutional golden rule capping debt at 60 % of GDP and cutting the deficit by half a percentage point a year, backed by a package of savings worth 140 billion euros by 2032, which is exactly the number Ben Hall at the FT came up with a few days earlier.

23:12The bond market liked it and French 10-year yields fell by 0.12 percentage points that day. Economists were less convinced, as the plan also includes cutting VAT on energy and food and lowering the retirement age from 62 to 60 for people who started work young. Olivier Blanchard, the former chief economist of the IMF, told the economist, unfortunately now that she has shown where she intends to find the money, there's zero credibility to her promise. The finance minister, Roland Lascure, said that he had the impression that she has converted to fiscal discipline. On the left, Jean-Luc Mélenchon, who is second in the polls, has a more direct solution.

24:00According to the FT, he has suggested that the French bonds held by the central bank could simply be thrown into the fire. And I suppose a bonfire would at least help with energy costs. The formal version from his party is to convert about 488 billion euros of French bonds held by the euro system into perpetual zero-coupon debt, which France would never repay and never pay interest on. Dara McFadden at the FT's unhedged newsletter, who used to work at the Bank of England and the ECB, pointed out the problem. The central bank created reserves to buy those bonds, and it still has to pay interest on those reserves to the banks.

24:45Cancelling the bonds just moves the costs to the central bank, while the bond market watches a G7 government default.

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26:06By 1797, with the king long since executed, the directory carried out what became known as the bankruptcy of the two-thirds. writing off two-thirds of the national debt. This solved the interest problem. The regime that did it lasted two more years before Napoleon took over. So, by French standards, the current budget negotiations are going reasonably well. With six months to go before the election, the bond market is looking at three main options. A minority government that may not be able to pass its budget, a front-runner promising an earlier retirement age funded by spending discipline, and her nearest rival proposing to settle the national accounts with a bonfire.

26:53You can sort of understand why investors want to be paid more to lend to France than to Germany. Meanwhile, the front-runner has already asked the ECB to step in and lighten the heavy interest burden as soon as France takes back control of its finances, which brings us to Frankfurt. So why can't the ECB just step in and fix this? Well, according to Morningstar, George Kramer, the chief economist at Commerce Bank, sees four steps the ECB could take if things get worse. Step one is to sound less keen on raising interest rates. Step two is verbal intervention, where central bankers solemnly declare that they're ready to use their emergency tools.

27:41Step three is to stop shrinking the ECB's balance sheet and start reinvesting maturing bonds with the reinvestments tilted towards France. And step four is to press the big red button and activate the Transmission Protection Instrument, or TPI. The TPI was created in 2022 to let the ECB buy a country's bonds with no size limits set in advance when market moves are unwarranted and disorderly. It's never been used, and the slight catch is the eligibility criteria. To qualify, a country is supposed to be following sound and sustainable fiscal policies, and France is currently under the EU excessive deficit procedure.

28:27According to Kramer, That doesn't automatically rule France out, but it doesn't help. Now, just to be clear, the ECB isn't going to let France collapse. But the TPI is an emergency rescue tool designed mainly for countries that don't need rescuing. Using it on a government with a 5.4 % deficit that may not be able to pass its budget would not go down well in Berlin. Christine Lagarde has been here before. In March 2020, she told a press conference that the ECB was not here to close spreads. Italian borrowing costs jumped immediately, and she then spent the rest of the day walking that comment back.

29:11Then there's inflation. With the war in Iran keeping energy prices high, the ECB has raised rates twice this year, and markets still see a good chance of another hike by December. Every hike makes France's debt more expensive. Lagarde has started telling European lawmakers that higher bond yields will slow the economy, which is a polite way of saying that the bond market is now doing some of her job for her. As The Economist notes, all of this sets up a game of chicken. Countries are supposed to fix their budgets before the ECB buys their bonds, but the European Union can't really survive without France.

29:55So, if a populist French president refused to cut spending and dared the ECB to let French bombs collapse, the economist reckons the president would probably win. Greece tried this in 2015. The ECB capped emergency funding to Greek banks. The banks closed for three weeks and Greece gave in. But, as we've been told repeatedly, France is not Greece. So, where does all of this leave France? Lionel Laurent at Bloomberg described the situation as less like Liz Truss's sudden blow-up and more like a slow squeeze. That seems to me like the right diagnosis. France does have some real protections. French officials pointed to high household savings, reliable tax collection and a stable banking system.

30:49But their biggest protection is a shared currency, the euro, and this is where that decision from 1999 comes in. As The Economist points out, French governments are still haunted by memories of May 1968, when students and workers shut the country down with a general strike. The government settled it with a deal that raised the minimum wage by about a third. Money quickly started leaving the country and the Bank de France spent much of its reserves defending the franc. De Gaulle refused to devalue at the time, but a few months after he left office in 1969, the franc was devalued by about 11%. When a country has its own currency, that's where the pressure shows up first, and it It tends to show up all at once.

31:41Today the Euro protects France from a currency run, so the pressure arrives more slowly. A spread over Germany that keeps creeping wider, an interest bill that eats a little more of the budget every year, and a steady turnover of Prime Ministers. For now the bond market is waiting. Parliament will spend the next couple of months deciding how much of Le Cornu's 43 3 billion euro package it's willing to keep. Moody's is due to review France's credit rating later this month. And on October 29th, the ECB meets to decide what to do about interest rates. If nothing changes, the arithmetic the economists laid out in July will keep running in the background.

32:27The debt will keep growing and the interest bill will keep rising by about 10 billion euros a year, and that's using July's interest rates. Meanwhile, the bond market will keep updating its league table. Thanks as always for tuning into the podcast. If you enjoyed this episode, you can support the show on Patreon. The link is in the show notes. Have a great week and talk to you again soon. Bye.

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