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Market questions: what next for French bonds?

Here are the big questions facing investors ahead of a new trading week.

How long does a reprieve for French bonds last?

After a burst of selling early last week, French debt was granted a reprieve with the 10-year benchmark yield easing back below 1.10 per cent. In turn, the divergence over 10-year Bund yields also pulled back from a four-year plus high.

Traders remain nervous after they failed to predict the two biggest political shocks of 2016, the UK’s Brexit vote and the election of Donald Trump.

In France, polls suggest the National Front leader Marine Le Pen will come second in the election in May, but investors have been pricing in the increased risk of an FN victory. The term redenomination risk has flared anew, with bond investors looking at the fine print of deals and whether euro-denominated sovereign debt could switch back into former national currencies.

Not helping ease worries over French debt, David Rachline, head of strategy for the National Front, said in an interview last week that only about 20 per cent of France’s total public debt “falls under international law [and would stay denominated in euros] . . . but for the rest we will have the right to change the currency”.

Such an outcome, say rating agencies, would probably amount to the largest sovereign default on record. No matter what the polls say, investors may look to reduce their exposure to France amid the uncertainty — although there are some who plan to look through the political clouds to focus on Europe’s broad economic recovery.

Rotation remains the name of the game — and perhaps for some time

Sector rotation remains a key aspect of trading, as investors await further developments that are mainly political in nature when they look at the US, UK and Europe. Waiting for more policy details from the Trump administration and the likelihood of them being passed by Congress, will keep investors on hold for some time. In the UK, the triggering of Article 50 looms, while Europe faces elections in Holland next month, followed by France in April.

Analysts at Bank of America Merrill Lynch note: “Although the markets are showing more concern, some analysts seem to be in a relatively sanguine mood going into the spring. By contrast, we see major risks looming, particularly around tax and trade policy.”

For all the doubts over how much policy stimulus will arrive via Congress, plenty are betting on the US economy picking up speed, hence a pronounced rally in junk-rated debt as investors anticipate stronger growth, deregulation and tax reforms. Junk bond funds collected $1bn in new money in the week to February 8, according to data from EPFR.

While US small-cap stocks as measured by the Russell 2000 index have lagged behind the record pace set of late by larger shares, the message from junk investors is very much one of keeping the faith in the Trump trade.

Why are UK analysts and investors talking about Brexit 2.0?

The new buzz term is Brexit 2.0. There is growing talk of the need for a more nuanced approach to trading UK shares that will become more important amid signs that the correlation between a weaker pound and stronger FTSE 100 could be facing changing dynamics.

Attention will focus on any parting of the ways for what has been a lock-step movement between the falling pound and rising stocks, led by companies with hefty foreign-based revenues. THE FTSE 100 has gained 18 per cent since June 24, while rising 7 per cent in US dollar terms.

After a strong performance for multinational blue-chips, investors are expected to take a more refined approach to identifying likely winners and losers as the UK’s divorce proceedings with the EU become clearer. Under that scenario, the current list of winners and losers could face a shake-up in the coming months.

Will UK inflation data worry London’s stock bulls?

Definitely. There are early signs that the correlation between a weaker pound and stronger UK stocks is facing pressure. The market’s reaction to Brexit is becoming more nuanced and has caught the eye of investors in UK assets.

Inflation data due on Tuesday will shed light on the extent to which the pound’s slide since the EU referendum has fed through into higher prices, raising the prospect of a squeeze on consumer spending that could start to make its presence felt on the stock market.

Signs of that came from Friday’s data showing a sharp year-on-year rise in the price of imported goods. That may have been why sterling failed to spark on the back of positive industrial and manufacturing figures and a cut in the trade deficit. With Brexit anxiety on hold and the UK economy in good shape, the pound looks ready to build on the modest uplift achieved so far this year. But inflation may be too big a hurdle for investors.

What can investors expect from Janet Yellen’s testimony to Congress?

Caution, with a tilt to hawkishness. Like the market, the Federal Reserve chair has begun the year in wait-and-see mode, unsure quite what impact President Trump will bring to bear on the robust US economy.

The January Fed meeting was as neutral as possible, but this week Ms Yellen will have to give voice to their thinking in her semi-annual appearance in front of the Senate banking committee. Not much has changed to bring the Fed off the fence on Trump, though the latest jobs data were a mixed bag. Still, the market correction that was the feature of January may have run its course, and the dollar is edging up again. Investors may be impatient, but there is little to divert them away from their end-of-2016 expectations on rates, tax cuts and fiscal stimulus. Ms Yellen will be careful not to stoke those expectations too far, but nor will she want to send the wrong signals to the market.

“ . . . She should be at worst neutral for a dollar into which 50 basis points of Fed hikes is priced the next 12 months,” say ING analysts. Valentin Marinov at Crédit Agricole is more bullish, saying her testimony along with a slew of data should shift the balance of risk in favour of a stronger dollar.

“Evidence of resilient domestic demand and inflation as well as indications that the Fed is on course to hike rates further should restore fading market confidence in the FX divergence trade,” he says.

Investors should lap up her every word — there won’t be too many more of these set-piece appearances from the outgoing Fed chair.

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