7 May 2012

Flash Update

Thoughts on the French Elections

Today's market reaction to the French presidential election resulted in significant losses for equity markets and the Euro currency against traditional safe havens like the USD and JPY.

The important question investors need to ask is this: Are we seeing a shift where markets begin to punish governments with higher yields because of a lack of commitment to austerity measures?

The short answer is no. Bond markets have thus far been lenient to Spanish and Italian governments. Although yields are off the lows for the year, they are way below the peaks reached at the height of the crisis back in 2011 before the ECB stepped in to support the market. One plausible reason for this is that austerity alone is insufficient to sustain Europe. Without economic growth, tax revenue collapses and the position of government finances worsen. That is why ECB president has called for a "growth compact" recently while German Chancellor Angela Merkel announced a growth agenda to her strategy for combating the Eurozone crisis. EU's Olli Rehn latest call for an investment drive also signal a softening of the austerity stance towards a more balanced approach to combating the European sovereign debt crisis. Hence, even before the elections, policy makers have already shifted their stance towards "less austerity, more growth".

Bond markets have already anticipated this shift in policy thinking, which is why yields in Spain and Italy are steady, TED spreads remain in a gentle downward trend while risky bonds like high yield and emerging market bonds made solid recoveries in the last two weeks, posting new highs.

Image courtesy of Stockcharts.com

Figure 1: Emerging Market Bonds

Image courtesy of Stockcharts.com

Figure 2: Treasury-Euro Dollar Spread

Image courtesy of Stockcharts.com

Figure 3: High Yield Bonds

The days or weeks ahead may be volatile, as newly elected policy makers make victory speeches in line with their electoral campaign. However, nothing drastic is likely to occur that the bond market did not anticipate. Watching bond markets will give a clue as to how the Eurozone crisis will unravel and its impact on global markets.

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