FRENCH LESSONS FOR EURO INVESTORS / THE WALL STREET JOURNAL ( VERY HIGHLY RECOMMENDED READING )

HEARD ON THE STREET

JULY 30, 2011.

French Lessons for Euro Investors .

By RICHARD BARLEY

Is the euro-zone apple rotten to the core?
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Greece, Ireland and Portugal are on bailout lifelines. Cyprus, significantly exposed to Greece through its banks and hit by economic and political turmoil, may be next. Spain has called early elections as it battles with its budget deficit and, along with Italy, is under the market microscope. Repeated emergency summits and pledges to protect the euro have fallen flat.


Cracks may now be emerging at the heart of the euro zone as government bond markets distinguish between French and German debt. French 10-year bonds, at 3.22%, now yield 0.68 percentage point more than German securities, far more than the 0.3-0.4 point gap seen for much of the year, and a level that has only been seen in the months following the collapse of Lehman.


Some of this is down to German bunds being viewed as a safe haven. Friday's widening in the Franco-German yield spread came about because German bonds rallied harder than French bonds, not because of a selloff in France. So some of the gap could be erased if risk aversion eased.


But that doesn't mean there isn't cause for concern. France has vulnerabilities: Of the six triple-A-rated countries in the euro zone, it has the highest deficit, 7% of gross domestic product in 2010, and the second-highest debt, at 81.7% of GDP. The International Monetary Fund warned this week that France might have to take more measures to hit budget targets in 2012-2013. France is vulnerable to slowdowns in Spain and Italy, and its banks are exposed to debt in those countries.


Other problems aren't directly of its making: the euro-zone crisis and the policy response to it. Each country that becomes affected simply reduces the number of options European government bond investors have, as well as increasing the strain on the strong countries that are on the hook to fund rescues.


After the initial round of bailouts, investors came to regard Spanish and Italian bonds as the way of betting on a progression of the euro-zone debt crisis. Now that those two are being engulfed by the crisis, investors simply may switch to play off France versus Germany instead.