France: the next domino to fall in the currency bloc?

The final reading of European December PMI’s released earlier today made for grim reading for Paris. French manufacturing PMI was revised down to 47 from 47.1, the lowest level since May. The second largest country in the currency bloc saw its reading fall below Greece, where the manufacturing PMI actually picked up last month to 49.6 from 49.2 in November. It also underperformed Italy and Spain, with both nations managing to eke out positive growth with readings above 50 at the end of the year.

As you can see in figure 1, France is now lagging the currency bloc’s overall PMI reading by quite some margin as it becomes the weakest link in the Eurozone. Interestingly, for now this fundamental underperformance in France has not hurt the performance of the Cac 40 stock index, which has followed its German counterpart the Dax quite closely in recent months, as you can see in figure 2, which has been normalised and shows how the two indices move together. This suggests that French equities have not yet been singled out because of weak domestic economic performance.

French – German bond yield spread worth watching

However, French bond yields are worth watching. The spread between French and German yields has widened in recent weeks and is now at its highest level since August. This contrasts sharply with the spread between Spanish and German and Italian and German yields, which have continued to narrow and are at their lowest levels since 2011.

Although the French – German spread is only 0.61 basis points compared with 200 + basis points for Spain and Italy, it is the pace of the increase in the spread that is worrying and the fact that the French – German spread is widening while the peripheral- German spreads are narrowing.

This does not suggest that danger is imminent, but it does urge caution. Sometimes the bond market is considered more astute than other financial markets, and if bond investors are starting to re-price French credit risk this could be the start of something more serious. If this is correct, then no doubt the FX and equity market will catch on at some stage, especially as we don’t see any signs that the French economy is ready to turn the corner yet.