France: Next stop Waterloo?

Late last night, Moody’s downgraded the credit rating of France to Aa1 from Aaa. At the same time they kept her on negative outlook. This did not come as a complete surprise as Standard & Poor’s lowered their rating to AA+ back in January.

Market reaction has been muted though with French 10-year yields adding less than 2 bp compared to Aaa-rated names like Germany, Finland and the Netherlands. France is still able to borrow money at a meagre 0.12% for two years and 2.11% for ten years which is only 72 bp higher than Germany has to pay.

Why the market hasn’t reacted

There are several reasons why the reaction has not been bigger: France is the second largest issuer of sovereign bonds in the Euro-zone with €1365bn outstanding trailing Italy at €1641bn but ahead of Germany at €1119bn and as markets are flush with liquidity due to central bank action, many investors find themselves more-or-less forced to buy French bonds (a trend which was compounded as ratings on Italy and Spain and their combined €2300bn+ market slipped ominously close to junk level).

Secondly, in this age of zero-returns a yield of 0.79% on French five-year bonds is almost double the 0.39% that German bonds yield. Thirdly, France investors (professional as well as private) have substantial funds to invest and French asset managers have a homeland bias (like so many others).

Pressure on France continues to build though

Hence, why last night’s downgrade is of no immediate concern it should in no ways be neglected. After the German reunification many described Germany as the ‘sick man of Europe’ with high unemployment and low growth whereas the French economy was humming along growing at and average rate of close to 2.5% during the last of the 1990s. Meanwhile, wage growth in Germany was meager as unemployment was high and the social-democratic government of Gerhard Schr