Euro Rates Watch - France snap election: Radical parties come to the fore

• The French snap election triggered a flight-to-quality in Europe, with the government likely to lose

• Various polls clearly suggest a win for the radical parties over the centrist government, which might lead to three different scenarios in our view:

• Scenario 1 (Far-right in power – Base case): The far-right gains a (relative) majority but most of its political program would not be possible to implement in those three years. Although we expect fiscal deterioration under this government, this should remain limited assuming the party does not want to trigger a debt crisis, which would scupper its chances to gain full power in the 2027 election

• Scenario 2 (Far-left in power – Negative): The most worrying scenario in terms of the economic and fiscal outlook would be a government led by the left coalition. Their political and economic program appears more radical than any other party and would create significant distrust in the market

• Scenario 3: (Hung parliament – Benign): None of the three political blocs obtain a clear majority, putting the government on hold for at least a year. This would not be a positive outcome, but it would at least mean no further deterioration in government finances, in contrast to the two scenarios above

• One thing is clear: in any of the possible scenarios described, France’s fiscal deficit is unlikely to go back to the 3% deficit target by 2027 as promised by the current government

• The French political turmoil has also disrupted the calm in the European debt market

• French bonds have underperformed significantly since the announcement of the snap election

• This also had spillover effects to other EGBs, particularly on Southern countries as their borrowing costs are historically closely correlated with the 10y OAT

• As such, we expect the 10-year OAT-Bund spread to remain high until there is more clarity regarding the outcome of the election and subsequent policies for the next three years.

The ‘’cordon sanitaire’’ is gone

The legislative election is a complex process (see box), which makes the outcome difficult to predict. The two biggest (and sometimes even the three biggest) parties that get past the first round then face a run-off in the second round. As it is unclear which party voters for the losing parties then turn to, this creates considerable uncertainty over the outcome, which helps explain the market volatility we have seen since the announcement of the snap election. The far-right (Rassemblement Nationale or RN) currently leads the polls at around 34%. However, the left coalition (so-called Nouveau Front Populaire or NFP) is closing the gap, with polls showing it as high as 28%-29% in recent polls. The NFP is composed of various left parties (including the green party, Les Écologistes) but is mainly dominated by the far-left party (La France Insoumise). Macron’s political party and his centrist/liberal allies still lags behind with 19%-20% of support among voters. As such, the current political landscape is clearly divided into three blocks. The coming week will also be crucial in setting the final picture, with the first TV debate among the three parties set to take place on 25 June.

Duel far-right versus far-left?

Most of the run-off votes in the second round will be between the three political blocs. However, it now looks increasingly likely that many will be between only the far-right and far-left, with Macron’s centrist party expected to fail to make it past the first round in many districts. The big unknown here is: who will Macron’s centrist voters back in case of a duel between the two political extremes? Looking at the previous legislative election in 2022, there were 61 duels between the RN and NUPES (left-coalition), and the RN won 34 of them. With the socialist party making an alliance with the controversial far-left (La France Insoumise), many centrist voters might find it more difficult to rally the left coalition even against a far-right opponent. Assuming Macron’s voters are split 50/50 in this scenario, then the RN party will likely do better than the far-left, as centre-right voters (Les Republicains) and other far-right parties (i.e. Reconquete) will probably mostly switch to RN. A duel between the RN and Macron’s party would lead to a more uncertain outcome. In the past, voters were willing to form a so-called Front Republicain to prevent populist parties coming to power. However, this dynamic has changed in recent years. Looking at the previous legislative election, the 100 duels between RN and Renaissance led to a 50/50 split of the electoral districts, so not really a united front to stop the far-right from winning. This time, we would still expect socialist voters (PS) to join Renaissance, but far-left voters are actually more likely to turn to the far-right, given the significant overlap in economic policies between the far-left and far-right.

Scenario 1 (BASE): How bad would a far-right government be?

Based on various polls, our base case is for the RN party to gain a (relative) majority in parliament. This will most likely lead to a so-called cohabitation with the incumbent president Macron. The prospect of a populist party forming a government in the second biggest European economy has of course triggered concerns. What concerns markets the most is the risk of a unsustainable fiscal policies, as well as a less constructive attitude towards Europe. Both far-right and far-left parties ran their 2022 campaigns on more expansionary fiscal programs, and with significant opposition to the EU project. Looking at some of the key measures announced by the RN party (see table below), their program clearly implies higher government spending than the current government. However, given the relatively short time between the surprise announcement and the election date itself, most parties have not published a complete program, and the RN party has remained vague on the costings and the timing of each measure.

However, some measures will be difficult to implement. The first constraint is the constitution, with some measures already deemed unconstitutional. These include proposed reforms to the right to asylum and the ‘’national priority’’, which has been a key mantra of the party for years, and aims to prioritize French nationals over foreigners on social aid. These measures are not possible under the current constitution which means it will need to be changed before adopting such measures. Other measures like the lowering of VAT on energy is against EU law, which states that the minimum rate should be 15%. In addition, the RN wants to reduce its contribution to the EU budget by EUR 2bn which is unlikely to go through but will still create political tensions with the EU if the RN were to push for this measure.

The other key constraint the RN party (also other parties) will face is financing. The country’s fiscal situation is already severely strained (as discussed in our macro outlook section below), with significant pressure already to reduce spending. This already rules out most measures of both the RN and NFP policy platforms, assuming they do not want to trigger a debt crisis in France. A key political figure of the party (who could be in the running for the Finance Minister role), Jean-Philippe Tanguy said ‘’the party will hold the line on deficits and present a credible plan. The market will be severe on us, so we really have no choice but to do so. ’’ These comments have already helped to reassure the market somewhat, with the French spread tightening slightly on the back of it. The assembly leader of the RN, Jordan Bardella, has also touched on this point in recent interviews. He acknowledges the current fiscal situation of France, and stated that his first move as PM would be to do an independent audit of government finances before coming with a clear plan on how implement the party’s policy objectives. This could be used as a political device to renege on costly promises, for instance, to lower the retirement age (this policy was notably absent from the party’s 8-point priority list). This approach of far-right populists moderating their policies when they gain power would mirror that of Georgia Meloni in Italy(1). In any case, as we explain below, economic and political reality (financial markets and the EU) will likely force the government to drop the most costly proposals, even if they do not immediately of their own accord. The question is whether they row back earlier or whether they try to hold on to these policies causing a more prolonged period of market stress.

The third and final constraint is domestic politics. Any incoming government looks set to be a minority government. Alongside the constitution, financial markets and the EU, this will act as a further constraint on the new government’s ability to act, with only policies that draw support from across the political spectrum likely to be passed. Of course, a scenario where the RN obtains an absolute majority would have more room to implement its political program which in that case, also means a likely worse fiscal outlook than priced in our base.

Scenario 2 (NEGATIVE): Left coalition would have a bigger macro and market impact

The main alternative scenario is for the left coalition (Nouveau Front Populaire, or NFP) to overtake the RN and gain the most seats in parliament. In this case, a Prime Minister from this coalition would need to be nominated. This decision is already likely to trigger some political divisions in the coalition as so far no one has dared to propose a name, and to some extent this will be determined by the number of seats each party gains. Indeed, socialist politicians have already highlighted that this coalition is not a happy marriage but more a forced coalition in order to conserve seats in the parliament. Despite it being politically advantageous to form an alliance, the controversial rhetoric of the far-left in recent months has caused many left voters to express opposition to such an alliance. Furthermore, the dominance of the far left is underlined by the fact that the NFP alliance’s political program is almost identical to that of La France Insoumise in the 2022 presidential election. This suggests that any coalition government that results is likely to be fragile and unstable.

Based on the manifesto, we judge that a left coalition government would have a much greater impact on France’s economic and fiscal outlook, with spending estimated to be much higher than for any other party. The coalition already announced a number of policies they wish to put in place in their 100 first days of power, and these are already estimated to cost around EUR 100bn. The most expensive of those measures would be the abolishment of Macron’s pension reform, to put the retirement age back at 60 from 64 at present. Noteworthy here is that this reform is judged to be crucial by rating agencies in the decision whether or not to further downgrade France’s sovereign rating.

Another key concern with this coalition gaining power, outside their radical economic program, is also their radical political approach. Although, the far-right has been historically the one perceived as anti-EU (being pro-Frexit for many years before retracting this at the last presidential election), the far-left has shown strong opposition to the EU as well. The manifesto already mentioned the desire to not respect the EU Stability Pact, and it wants to exit most International free trade agreements (eg. CETA, MERCOSUR).

While the far-right has recently sought to re-assure investors, no such attempt has been made by the far-left. Thus, we expect further political turmoil and likely significantly wider spreads in this scenario than in our current forecast.

Scenario 3 (BENIGN): Is no government at all a possibility?

There is also a significant probability that the political outcome does not give a clear majority to any of the three political blocks. Jordan Bardella from the RN, already mentioned that he would refuse to be nominated Prime Minister if the RN does not get the absolute majority. This would lead to an unprecedented situation for France as previous dissolution always led to an absolute majority for a political party.

In this type of situation, the president could even decide to keep its Prime Minister in place and try to compose a government with a so-called ‘Union Nationale’ by forming a government with some of the traditional right- and left-wing political parties together with the centrist parties. However, in our view this would only be feasible if the centrist alliance manages to obtain sufficient seats and be (or close to be) the second biggest political party in the parliament. Of course, the centrist alliance would still need to convince those parties to join them despite their rejection to form a coalition for the first election round.

This political outcome would most likely lead to a longer period of uncertainty and volatility. Political parties would need to go for another round of tough political negotiations to avoid a political blockage for the coming year. The president cannot dissolve the assembly again for a year and even a resignation of the president would not trigger a new legislative election and the new president would still need to compose with the elected parliament. Thus, this would likely just leave the French government on hold for the coming year with no new economic reforms to be adopted. Although, this would not be a positive outcome for France’s economic outlook, this type of scenario would at least mean no further deterioration in government finances, in contrast to the two scenarios discussed above. However, it would also mean no fiscal consolidation.

Macro Outlook: RN or NFP platforms would make a bad fiscal situation much worse

Even before Macron’s snap election call – and the prospect of a less fiscally responsible new government – France’s government finances were already in a parlous state. Despite major efforts of the current centrist government to rein in spending, in particular via the flagship controversial pension reform of 2023, the budget deficit is projected to stay stubbornly above 5% of GDP over 2024-25 – far in excess of the EU’s fiscal rules target of 3% of GDP. As a result, following a short period where there was a declining debt-to-GDP, slowing nominal GDP growth combined with a rising interest burden is expected to drive the debt ratio higher again over the coming years, from 110.6% of GDP as of end 2023, to around 112% of GDP in 2024, and rising at a 1-1.5pp annual pace thereafter (this assumes no change to current enacted policy). Given France’s unsustainable debt trajectory and its persistent breach of the EU’s fiscal rules, this week the European Commission officially placed France into its Excessive Deficit Procedure (EDP). This will kickstart a negotiation between the government and the Commission over how to reduce the deficit over the coming years.

Assuming the incoming government seeks to cooperate with the Commission, this would significantly constrain what the new government can do. As discussed above, despite the historically Eurosceptic tendencies of the RN party, the recent efforts to assuage market concerns suggests RN is likely to be more cooperative with the Commission than a leftwing Melenchon-led government. In either scenario, we assume a looser fiscal policy than under the current government, with significantly greater upside risk to the deficit in the case of a NFP win. Based on currently proposed plans, a RN-led government would entail deficits persistently above 6% over the coming years, while a NFP-led government implies a deficit of nearer to 8%. In contrast, the current centrist government’s planned modest fiscal consolidation would put the deficit on a gradual path back to EU’s deficit target of 3%, but still far behind the target even by 2027 (see chart below-right). Note that with these ballpark figures we assume there will be some positive growth impact from the fiscal expansion in the RN and NFP scenarios, which to some extent would offset the negative impact on the deficit. But the net effect would still put government debt on an unsustainable trajectory.

Given the high degree of uncertainty at this point, our current base case for the economy assumes no major changes to fiscal policy, but the risks to the near-term growth outlook are tilted somewhat to the upside given the increased likelihood of some fiscal easing. However, any boost from this is likely to be short-lived, as it will only mean a more painful fiscal adjustment will be necessary further down the line. In a worst-case scenario, financial markets – likely combined with pressure from European authorities – could accelerate the path to this day of reckoning and nullify even the short-term growth impact. We will update our macro base case following the outcome of the election and when there is more visibility on the fiscal trajectory.

French spread won’t go back to its pre-election level anytime soon

So far most of the widening in French spread is mainly due to the uncertainty and political instability related to the election. After the 7th of July, the direction OATs take will depend on which political party is going to govern for the next three years. French underperformance already led the 10y bond yield to trade above its Belgian peer, and even in line or slightly higher than peripheral countries like Portugal, which is lower rated. This can be explained by uncertainty over the fiscal outlook, which is clearly darkening for France, while it continues to improve for some peripheral countries like Portugal and Spain. However, other EGBs were also impacted by the French election announcement, particularly southern countries where their borrowing costs tend to correlate strongly with France 10y yield, as shown in the graph below.

Will the ECB intervene if OATs drop further?

One of the key questions emerging after the 10y spread between France and Germany widened by as much as 30bp over the past week, is how far could the spread go before the ECB intervenes? What makes this an even more pressing issue is that France (as well as Belgium and Italy) were put in the excessive deficit procedure (EDP) by the European Commission on 19 June. This matters because one of key conditions allowing use of the ECB’s Transmission Protection Instrument (TPI) is that countries cannot be on the EDP list. On the other hand, should volatility spill over significantly to other peripheral countries – causing moves that are out of line with fundamentals for those countries – then the ECB would have to intervene. Under the TPI, the securities of most eurozone member states would likely be eligible (Italy and Belgium together with France are notable exceptions). This would likely to be the ECB’s first response.

In a scenario where a future French government ploughs ahead with a fiscally reckless plan, this would likely cause the market to lose trust in the country’s debt and push the 10y French spread well over the 100bp level, possibly dragging other EGBs with it. With France on the EDP list, we think that the ECB would need to come up with another emergency program to intervene to stop any further fragmentation risk, though market stress would need to be severe. However, this is unlikely to be done without the government making concessions and agreeing to adopt a more responsible economic and fiscal policy going forward. Indeed, the scaling back itself of unsustainable fiscal policies would itself likely calm markets and perhaps remove the need for any intervention. A case study for this was the UK’s experience with Liz Truss’s mini-budget in 2022. Market pressure ultimately triggered an abrupt U-turn on expansionary fiscal policy and the downfall of the government, ruining the incumbent Conservative party’s reputation for economic stewardship. The fate of the Conservative party – which is now set for a historic defeat in the UK’s upcoming elections – may serve as a warning to any new government in France of the pitfalls of fiscal largesse.

Indeed, our base scenario sees an incoming RN government adjusting its current political program to a certain degree to avoid market turbulence. We would still expect fiscal slippage, particularly as this government is unlikely to engage into fiscal consolidation in the upcoming three years. Thus, it is now very unlikely to see France’s deficit reach the 3% target by 2027 as previously planned by the current government. This represents a difficult balancing act for the RN as on one hand, they will need to satisfy their electorate after promising so much over the past years but on the other hand, not trigger a debt crisis as this would lead to important economic impact and ruin their chance of winning the presidential election in 2027. Thus, as political uncertainty fades and the RN government translates its recent reasonable political speech into a cautious economic program, we expect spreads to stabilize and tighten later in the year (see table below). However, we continue to see France slightly underperform its EGB peers given the country’s political divisions and its deteriorating fiscal and debt outlook. This could push France trading closer to lower-rated countries and be considered as a sort of “crossover peripheral”. In our view, this offers attractive opportunities for investors interested to come back to the European debt market once the political uncertainty fades. This is indeed a good opportunity to buy the debt of certain sovereigns with a good economic fundamentals (i.e Spain or Portugal) at a cheaper levels than a couple of weeks ago.

(1) Although it should be noted that Meloni’s party to begin with is more economically liberal than RN, i.e. it fits the more traditional right-wing conservative political mold. Furthermore, Italy is also more dependent on the EU funding than France.