Markets tolerate French paralysis as long as yields stay high

The Assemblée nationale in Paris, the French parliament. Photo: Jarosław Baranowski/Wikimedia.

France has been thrown into renewed political turmoil by the resignation of Prime Minister François Bayrou, but the impact on its debt market has been muted. A global bond rally, fuelled by weaker US economic data and falling long-term Treasury yields, has buoyed demand for French OATs, masking the country’s deepening fiscal vulnerabilities.

The contrast is striking: while France drifts without reform and faces record debt levels above 114 percent of GDP, its bonds continue to find eager buyers. Investors point less to confidence in Paris than to global forces that have lifted OATs alongside peers: tight credit spreads, strong demand for carry, and a rally in long-dated US Treasuries. The question now is how long this backdrop can shield France from the consequences of political paralysis and fiscal drift.

For Aymeric Guedy, fixed income portfolio manager at Carmignac, last week’s auction success reflected that global backdrop more than domestic stability. “We are in a global environment where spreads are tight and risk premia are compressed. Investors are buying the long end everywhere, in US Treasuries, in Bunds, and in OATs, because weaker US data has revived recession fears. France benefits from that context, not just from its own fundamentals,” he told Investment Officer.

Paradox

The global backdrop helps explain the paradox: political drift in Paris, yet steady demand for French debt. But valuation and liquidity also matter. “At more than 80 basis points above Bunds, the 10-year OAT seems to price a lot of bearishness already,” said Romain Grandis, portfolio manager at DNCA. “Large institutional investors are still keen to buy French debt when yields go up.”

“France is a large and very diversified economy, that is a AA-‘risk’, with outstanding liquidity on the market,” Grandis added. “Even in a scenario where all credit agencies were to downgrade its rating, France would still be six notches above high yield and still three notches above Italy, even when taking the best rating for the latter.”

Others see tactical factors at play. Allianz GI’s Matthieu de Clermont argued that the September auction reflected investor pragmatism. “When the issuance came the government was already expected to fall. Some could have seen the auction as a tactical entry point,” he said. With yields back at levels not seen since 2011, domestic buyers in particular were ready to step in.

Political limbo

For De Clermont, the bigger risk lies in political limbo. “A caretaker Prime Minister would once again raise questions about the government’s durability, while a dissolution followed by elections could result in another hung parliament, prolonging uncertainty and potentially affecting investor sentiment.”

Berenberg’s veteran chief economist Holger Schmieding warned that the real problem is political and fiscal drift, not collapse. “The policy paralysis in Paris spells trouble for France and Europe. It makes it even more difficult for Europe to stand up to Trump and Putin. Even more so than before, the onus is now on Germany to take the lead to defend European interests,” he told Investment Officer.

Ratings downgrades may arrive soon; Fitch could act as early as this week. But Schmieding judged that “a genuine financial crisis with a self-reinforcing doom loop remains quite unlikely for the time being.”

Stubborn deficit

AXA Group’s Gilles Moëc pointed out that mainstream parties all reject the radical solutions of populists, but cannot agree on what drives France’s stubborn deficit: tax cuts or rising social spending.

“A plausible outcome is that the mainstream forces, from the centre-left to the centre-right, ultimately agree on a minimal compromise which would give France a budget for 2026, thus helping to keep the pressure from the bond market to an acceptable level – but without providing a proper trajectory-improving consolidation,” he said.

PGIM’s Guillermo Felices sees the risk of major contagion to other euro debt markets as limited, citing a solid macro backdrop and the ECB’s transmission-protection tool, TPI. “For long investors who can tolerate volatility valuations are interesting, curves are very steep, twice as steep in France and Italy than in the US, and hedged yields are attractive especially for US investors,” he said.

French debt owned abroad

Still, Carmignac’s Guedy warned that France could become the eurozone’s main weak spot if global market sentiment turns. Stabilising the debt-to-GDP ratio would require a deficit reduction of 3.5 percent — “an effort with no precedent in French history,” he said — while more than half of French government debt is held by foreign investors. “If we enter a risk-off environment and global buyers reduce exposure to spread assets, France will suffer disproportionately. Unlike Germany or even Italy, the fiscal room to manoeuvre is extremely limited.”

For now, markets seem willing to tolerate paralysis. OAT spreads over Bunds are near their widest in a decade but remain far from crisis territory. Investors continue to prize OATs for their depth and liquidity, especially when yields are attractive relative to safer German paper. The ECB’s implicit safety net further supports this confidence, even if Christine Lagarde must “mince her words carefully” on Thursday to avoid signalling either indulgence or abandonment, as Schmieding noted.

The paradox of French debt is that markets are willing to live with a stalemate as long as liquidity and yield compensate for the risk. The danger is that this tolerance entrenches complacency in Paris, allowing deficits to drift, reforms to stall, and Europe’s second-largest economy to play a weaker role just as global challenges mount. For Berlin, that means carrying a heavier burden.

Germany as fiscal anchor

“President Macron can still set foreign policy for France,” Schmieding said. “But he does not control the purse strings and would struggle to get any international agreement ratified by parliament.” That leaves Germany, whether it wants the role or not, as Europe’s reluctant fiscal anchor.

“It is clear that France’s political quagmire will not be resolved this year, and perhaps not until the 2027 presidential election,” said Alex Everett, investment strategist at Aberdeen. “This will likely keep OAT spreads elevated – at least around current levels – for months to come. We remain short OATs against peers.”

“French OATs are showing the strain,” said Laura Cooper at Nuveen. “The 10y spread over Bunds remains near the widest in more than a decade, surpassing even the risk premium baked into Greek debt. A push toward a 90–100bps spread - if fiscal profligacy fears escalate - could tempt bargain hunters, but for us, it’s not enough to close our structural underweight.”

Guedy underlined the need for caution among investors, even though there could be “some respite” in the short term. Fiscal metrics, he said, are “flashing red”. “No politician will be able to make the unprecedented efforts that are required right now.”