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Goldman Downgrades French Bonds Ahead Of Elections

Roughly at the same time as today's French election narrative shifted again as traders started paying attention to the suddenly surging in the polls far-left candidate Jean-Luc Melenchon, which pushed the Euro to the lowest level in a month, Goldman has come out with a recommendation to short June OAT futures (OATM7) at 147-72, for an initial target of 144.00, and stops on a close above 150.00,

In the note, Goldman's Francesco Garzarelli writes that a victory by a moderate reformist presidential candidate (Fillon, Macron), which is the base case at the bank, would result in a narrowing of French bond spreads but may be offset by a selloff in core rates. He writes that the “fair level” of 10-year spread to bunds is in the region of 30bp-40bp, from 70bp currently, according to Goldman

The bank adds that it expects French bond spreads and yields to come under upward pressure if the first round of election were to result in a strong showing of anti-establishment candidates (Le Pen, Melenchon), while by contrast, U.S. Treasuries may instead rally on the event, on the back of flight-to-quality flows.

Full excerpt below:

Duration Looks Expensive: Open Tactical Shorts in French OAT

US 10-year Treasury yields have fallen around 30bp since reaching a local peak of around 2.6% before the FOMC meeting on 15 March. More than two thirds of the decline in US bond yields over this period reflects lower real rates, with 'break-even' inflation more or less stable.

As yields have fallen, investors appear to have pared back their short positions. According to CFTC data up to 04 April, net speculative short positions in 10-year Treasuries futures have gone back to levels last seen before the election of President Trump.

Our empirical analysis on cross-country spill-overs indicates that the rally in major bond yields over the past three weeks - including US Treasuries -has been driven primarily by the fall in German yields to fresh lows. In bigger-picture terms, our models suggest that US Treasuries are still trying to lift global rates up, while JGBs and more recently Gilts have been pulling them in the other direction. German yields are the ‘tie-breaker’ in these dynamics.

Our Sudoku framework, which relates 10-year government bond yields to evolving consensus expectations on future growth, inflation and monetary policies, suggests that US Treasuries remain relatively better aligned to their macro underpinning than their counterparts in Europe and Japan. That said, the valuation gap between Treasuries and the other G-4 bond markets (calculated from 2000 onwards) has declined from the 90-th percentile in early March down to the low 80s. Even US Treasuries are now approaching levels that qualify as moderately ‘expensive’ in absolute terms

The combination of cleaner positioning and absolute and relative valuations offers a better entry point for shorting duration. After recommending a tactically neutral stance in Q1 (our end-March forecast for Treasuries was 2.5%), we expect the second quarter to mark a transition to higher yields and continue to forecast that Treasury yields end the Summer at 2.75-3.00%.

Reflecting on the residual valuation gap between the US and Europe, however, and consistent with our idea that the global bond premium is being eroded largely by the actions of the ECB and the BoJ, we are of the view that, for a move upwards in Treasury yields to be sustained, core European markets need to participate.

We recommend going tactically short June French futures (OATM7) at 147-72, for an initial target of 144.00, and stops on a close above 150.00. This position allows one to take a directional view on duration in a market that scores as very expensive on our valuation metrics.

In relation to the risk to this trade emanating from the political sphere, a victory by a moderate reformist candidate (e.g., Fillon, Macron) - which is our European Economics team base case - would result in a narrowing of French bond spreads (the 'fair level' to Bunds is in the region of 30-40bp, from 70bp currently) but offset by a sell-off in core rates. We would expect French bond spreads (and yields) to come under upward pressure if the first round of the Presidential election were to result in a strong showing of anti-establishment parties (e.g., Le Pen, Melenchon). By contrast, US Treasuries may instead rally on the event, on the back of flight-to-quality flows.