By Alun John and Dhara Ranasinghe LONDON (Reuters) -The prospect that France's minority government could collapse soon triggered a sharp selloff in French stocks and bonds on Tuesday, pushing
French Stocks and Bonds Plunge Amid Government Stability Concerns
Impact of Political Instability on Financial Markets
By Alun John and Dhara Ranasinghe
Market Reactions to Confidence Vote
LONDON (Reuters) -The prospect that France's minority government could collapse soon triggered a sharp selloff in French stocks and bonds on Tuesday, pushing political risks from the euro zone's second biggest economy back to the forefront of investors' minds.
Analysis of Bond Yields and Spreads
Three main opposition parties said they would not back a confidence vote which Prime Minister Francois Bayrou announced for September 8 over his plans for sweeping budget cuts.
Future Implications for French Economy
France's blue chip CAC40 index fell over 2% to its lowest level in almost three weeks, having fallen 1.6% late on Monday. Banking giants BNP Paribas and Societe Generale slid more than 6% each, while midcap stocks slid nearly 3%.
Meanwhile, 10-year French government bond yields briefly rose to 3.53%, the highest since March, before steadying at 3.50%. When a bond's yield rises, its price falls.
The gap between French and German 10-year yields, a gauge of the premium investors require to hold French debt, widened to around 79 bps -- its largest since April.
Analysts had anticipated a return in French political risk come autumn as the government tries to secure support for steps to improve France's fiscal position.
But Monday's developments came as a surprise.
If Bayrou loses the confidence vote in the National Assembly, his government will fall. President Emmanuel Macron could then name a new prime minister, ask Bayrou to remain head of a caretaker government, or he could call a snap election.
"It looks like Bayrou will be gone. It will be hard for Macron to install another Prime Minister if a confidence vote is lost, without going to new Parliamentary elections," said Mark Dowding, chief investment officer for BlueBay fixed income.
"This should weigh on French debt in the coming weeks on the risk that Le Pen's National Rally ends up winning a majority," said Dowding, adding that he anticipated a further widening in French bond spreads in the weeks ahead.
The German-French spread reached 90 basis points late last year.
Meanwhile, the gap between French and Italian 10-year yields, which was around 150 bps two years ago, is now around 10 bps.
But French Finance Minister Eric Lombard said on Tuesday he was "certainly not resigned" to the idea of Bayrou's minority government falling next month.
Lombard also suggested there was a risk the International Monetary Fund would have to intervene in the economy if France doesn't get its finances in order.
Latest developments are also a reminder that French turmoil could temper sentiment towards "Make Europe Great Again" trades, with European economies benefiting from U.S. policy uncertainty and steps to boost long-term growth prospects from heavyweight Germany.
HOT SPOT
Banks bore the brunt of the selling, with their stocks the biggest faller by some margin in the blue chip index. The cost of insuring Societe Generale's against default rose to its highest since June, and BNP Paribas' to its highest since July.
Bank shares are often the first to fall on budget concerns in France.
"Higher sovereign spreads normally translate into at least partially higher wholesale funding costs for banks, putting pressure on net interest margins," said Johann Scholtz, senior equity analyst at Morningstar.
"The instability also does not augur well for economic growth in France, which feeds through in the outlook for French banks."
It's also a fragile time for global bond markets, with investors increasingly worried about high government debt and the ability of big economies to exercise fiscal constraint.
Bayrou is trying to tame a budget deficit that hit 5.8% of gross domestic product last year, nearly double the official EU limit of 3%.
European markets in addition have seen substantial buying recently, meaning there are plenty of investors left to sell.
"There is potential for spread volatility, looking at institutional participation in government bond markets, a lot of money went into Europe," said Tim Graf, head of EMEA macro strategy at State Street.
"We are heading into budget season which is why this (the French selloff) is happening," he added, "all of these countries are unable or unwilling to restrain spending, that includes France and Britain."
(Reporting by Alun John and Dhara Ranasinghe, additional reporting by Mateusz Rabiega in Gdansk and Matheiu Rosemain in Paris; Editing by Ros Russell)
