LONDON: French bonds outperformed most of their euro zone peers on Monday after Moody's spared the region's second largest economy from a fresh credit rating downgrade even though Paris has overrun its deficit targets.
The French government's admission last week that it would take longer than planned to cut its deficit as agreed with European partners had prompted speculation in the market and in the press that a one-notch downgrade was all but inevitable.
Moody's kept its rating on French bonds at Aa1 late on Friday but maintained its negative outlook, citing the difficulties of pushing through reforms.
French 10-year bond yields fell 4 basis points to 1.35 percent, outperforming other euro zone bonds whose yields were also lower on expectations that economic data due this week will add to signs of anaemic growth in the region.
Their yield spread over benchmark German Bunds tightened 2 bps to 38 bps.
"There's some limited reaction on the back of Moody's decision to keep the rating but I wouldn't have been surprised to see a very limited reaction even if there was a one-notch downgrade," said Patrick Jacq, a strategist at BNP Paribas.
"It's still a very liquid market and you still have some spread above German paper. In such conditions there's little risk at the moment of a decent sell-off on French paper."
QE PRESSURE
Market focus is also on European Central Bank President Mario Draghi's appearance at the EU parliament later on Monday, which follows tepid demand for the bank's latest scheme to push cheap long-term cash through the financial system.
If purchasing manager surveys on Tuesday point to more weakness in the euro zone economy, it will add to speculation that Draghi sooner or later will be forced to embark on full-scale asset purchases including government bonds, a tool known as quantitative easing.
A fall in the ECB's preferred measure of the market's long-term inflation expectations to its lowest this year on Friday, coming after the small take-up of the four-year loans, exacerbated deflation fears and increased speculation about QE.
The five-year, five-year breakeven forward rate, which measures roughly where markets expect 2024 inflation forecasts to be in 2019 fell to around 1.91 percent on Friday, within a whisker of 2010 lows of 1.90 percent.
Expectations that the ECB will eventually have to undertake more aggressive monetary stimulus were also supporting demand for lower-rated euro zone bonds.
Italian 10-year and Portuguese yields were slightly lower.
Spanish yields retreated slightly from lows hit last Friday after voters in Scotland rejected independence from the United Kingdom, easing concerns that separatists in wealthy Catalonia could be emboldened by the Scots.
"We're still bullish periphery despite the poor TLTRO take-up, as this should bring QE closer. We are still expecting 20 percent of TLTRO cash to go into carry trades," RBS strategists said in a note.
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