No one is buying OATs. Will the ECB?

French government bonds (OATs) keep on breaking records and psychological barriers, with the latest being 10-year yields smashing through 5% for the first time since 2002 this week. We have observed the situation closely, and while French risk assets have understandably underperformed peers with some contagion across to Italian and Spanish government bonds among others, there has been little sign of panic in the price action.

This begs the question why markets have not lost their nerve in the face of a relatively large G7 economy seeing a substantial increase in its funding costs, and as a follow-up, if, when and how the European Central Bank might intervene.

We see a couple of reasons why markets have not panicked. First, French banks are fundamentally in good shape and neither their solvency nor their liquidity is being called into question. They have global exposures, diversified business models and their exposure to OATs is not particularly high. Bank bonds and equity valuations were frequently hit hard by sovereign stress during the European sovereign debt crisis many years ago, but the more robust balance sheets of today have increased their resilience. Post-crisis regulatory changes have strengthened banks' credit profiles significantly, and one specific goal of these efforts was to break the link between sovereign and bank debt. To the extent that banks are at the centre of the allocation of credit in an economy, no panic at banks decreases the chances of this shock spreading to the real economy.

Second, the ECB has at its disposal a vast array of tools it can deploy to calm markets if needed. Just as in warfare, deterrent weapons work best when the threat of their use renders their use unnecessary. A bond trader anticipating further weakness in Italian government bonds (BTPs) due to contagion from France, for example, might think twice about shorting BTPs in size given the ECB has powerful facilities that could sour those shorts very quickly.

Importantly, these facilities were not created to help the fiscal accounts of any country. That said, the ECB may need to act in some way at some point if pressure continues, and there is currently plenty of market chatter around what the threshold for intervention might be. We do not think that threshold would be a "number" such as the spread between OATs and German Bund yields reaching a certain level and automatically prompting the ECB to buy a determined amount of OATs.

The most important thing for the ECB is that financial markets work in conjunction with its monetary policy decisions to deliver the right amount of tightening (or loosening) of financial conditions to the economy in keeping with its inflation target. We think the ECB would not hesitate to intervene if monetary policy transmission was impaired, but at this stage we do not see evidence of this happening. If there were disorderly reactions in Italian and other government bond markets, then the ECB’s first steps would likely be an attempt to calm markets with verbal intervention, or a reduction or termination of its quantitative tightening (QT) programme. Going into the market with a sizeable bid for bonds would a final option and would only be used if stress were a lot more severe than we currently see.

For now, even with yields at multi-decade highs, OATs are struggling to “catch a bid” in market parlance. Traders need a catalyst to take long positions, and the plausible but unspoken threat of some grand scale intervention is not going to make the cut just yet. Beyond a possible ECB intervention, France needs to signal concrete action to get its fiscal accounts in order before investors would be tempted to jump in at these levels.

To turn this around, in the coming weeks markets would like to see the approval of a reasonable budget, and ideally a proper economic plan from Rassemblement National leader Marine Le Pen, who is currently priced as most likely to win the presidential election in April 2027. Neither would be a particularly long-term solution or make OATs a screaming buy, but they might put some sort of ceiling on yields between now and April and potentially spark a rally if Le Pen were to unveil a credible plan for reducing the deficit, for example.

Currently, no one seems to be standing in the way of OAT yields. We are certainly not putting our hands up and our exposure remains at zero.