Hedge funds bet France is more peripheral than core

Date: Friday, August 31, 2012
Author: Laurence Fletcher, Reuters

Hedge funds are going against market consensus and betting that ultra-low French government bond yields are unsustainable, believing a sluggish economy and the new government's policies will eventually force up borrowing costs.

Investors have generally given France the benefit of the doubt this year, treating it as a core euro zone economy despite its debt. Its bond yields have, as a result, generally tracked Germany's rather than struggling Italy's or Spain's.

But many macro funds now think the yields, which have collapsed this year, cannot remain around the lowest levels seen for more than 20 years. France's economy, after all, is teetering on the brink of recession.

The funds, which are often at the leading edge when it comes to future market moves, are also sceptical about the policies of French President Francois Hollande, who was elected in May.

These include raising taxes on the rich and cutting the pension age to 60 for some workers, risking a reduction in tax revenues, increasing pressure on France's welfare system and hitting its credit rating.

"The market seems to be looking at France as a safe haven, yet we very much believe that French yields should be converging towards Italian and Spanish yields rather than to those pertaining to Germany," said Pedro de Noronha, managing partner at London-based Noster Capital.

French two-year yields were down at 0.17 percent on Thursday from around 0.6 percent at the end of last year, and just 0.19 basis points above Germany. Italian and Spanish yields are 3.04 and 3.64 percent, respectively.

The French 10-year yield, meanwhile, has dropped to 2.14 percent, about 100 basis points below where they were at the end of last year.

"We have high conviction that, at some point in the not-too-distant future, French public finances will start to deteriorate markedly thanks to Mr. Hollande's irresponsible socialist policies," de Noronha said.

Managers have placed their bets in a range of ways. De Noronha is shorting the bonds and has offset part of the risk with higher-yielding senior secured corporate bonds. Shorting means betting on a lower price for a security in the future.

Others have bought credit default swaps CDS.L - which are designed to pay out in the event of default - whilst buying German bonds, which they believe will perform better.

CDS prices would rise if France's debt prospects worsened.

Others have simply been shorting both French and German bonds in the belief both yields are too low.

Firm positioning data is notoriously difficult to find for this kind of thing, but some hint can be taken from bond lending, at least some of which will as a result of shorting.

The quantity of French bonds out on loan has risen to $52.2 billion from $50.5 billion a month ago, according to data group Markit.

HEADWINDS FOR HOLLANDE

France's 2 trillion euro economy faces plenty of headwinds. It is likely to slip into a shallow recession in the third quarter, its central bank said this month, while government growth forecasts for 2013 look set to be revised downward.

Meanwhile, jobless numbers are at a 13-year high, with more job losses expected in September.

There is also the debt issue -- which after all is the basis for the euro zone crisis.

France's debt to gross domestic product is around 90.5 percent, which is far higher than suffering Spain's 80.9 percent.

As for annual overspending, France's deficit as a proportion of GDP is headed to 4.5 percent this year. Italy's is 1.9 percent.

By these standards, the French economy would appear more peripheral than core.

Nevertheless, yields have continually defied the pessimists, hurting hedge funds who had already bet against them.

"It didn't work particularly well. But some macro funds are (still) riding that sort of trade," said Scott Gibb, partner at $1.3bn fund firm Cube Capital, who believes yields were driven down by purchases by central banks and insurance companies chasing small but positive real yields.

"The French should be paying more to borrow given our expectation of economic deterioration there... France has got a lot of issues to solve. With likely slowing growth (under ongoing austerity) and potential recession, increased spending and taxation could create a very tough environment."