Back in February, dramatic richening in the front-end of the German curve garnered quite a bit of attention. It was, as we called it, a “holy Schatz” moment.
Some commentators were quick to attribute plunging German 2Y yields to a flight-to-safety bid as Marine Le Pen’s odds of winning the French presidency rose. That theory was seemingly debunked when the impact of ECB buying below the depo rate was laid bare:
(BofAML)
A little more than a month on, and most indicators have “Le Pen risk” dissipating materially including French CDS which fell below 50bps for the first time in weeks earlier this month:
But one indicator hasn’t budged: the OAT-bund spread.
Below, find an interesting bit from Deutsche Bank who notes that despite the ratio of CAC and DAX implied volatility and the level of implied volatility of Eurostoxx banks declining appreciably to near January lows, the 10Y France-Germany spread is still flashing red – or at least yellow.
Via Deutsche Bank
The market has become fairly comfortable with the French election risk and does not expect a surprise win for Le Pen. The odd-makers are now ascribing only ~25% chance for a LePen win, which is around 10pp lower than the peak seen around late February/ early March. The gap between the chances of the either Fillon or Macron vs. LePen has widened to as much as 45% which is the highest since late January. Against this backdrop it is not surprising that the overall level of concern around the French election have declined.
However, we find that although the absolute level of French 10Y yields have declined by ~15bp from their recent peak the France-Germany 10Y spreads has remained reasonably stable at around 65bp and has not tightened towards the 50bp level seen at the start of the year. This is despite the fact that some other market indicators such as ratio of CAC and DAX implied volatility or the level of implied volatility of Eurostoxx banks has declined appreciably and are close to the lows seen in early January (see Figure 2 and Figure 3). It would appear that the OAT-Bund spread is lagging relative to volatility measures in equity markets in response to the reduction in French election risk. However, it could be argued that given the widespread overweight positioning of conservative investors in French government bonds and the prospect of tapering if the French election risks does not materialise is weighing on the OAT-Bund spread.
