Beyond the French « No » vote…

The European Union’s Nice Treaty was widely perceived as a disappointment in terms of bringing much needed progress on reform and innovation ahead of the challenges of enlargement. The new Constitution proposed significant improvements on these issues with main points of interest for the markets being improving the flexibility of decision making in the enlarged Union delegating power from national governments towards the Union.

A French "No" vote to the Constitution would jeopardise these achievements. The strength of opposition in opinion polls has taken France by surprise. Over the past two weeks, however, it seems that the "Yes" camp is adopting a more aggressive strategy. All members from the main French parties, including the UMP and the Socialists, have been mobilized. The next two weeks will be key to determine how the odds are turning.

So far it appears that there is no clear plan B in case of a "No" vote from France. Indications are that the ratification process in other member states would continue. Therefore, the capacity of manoeuvre for France in any future renegotiation process will be linked to the prospects of other member states also joining the "No" camp.

I am doubtful that the EUR will suffer significantly versus the USD. The "No" vote should not be interpreted as a political mandate from the electorate to destroy euro-zone. Also, the lack of improvement in US twin deficits limits the capacity for the USD to establish a structural positive trend against the EUR.

In my view, the impact is more likely to be felt on the periphery of the Union, namely on Turkey, where the risk of a setback in the EU accession process could prompt capital flight after last year’s heavy inflows, against a backdrop of a declining carry attraction of the TRY and a wide current account deficit. The currencies of some new EU members, especially PLN and HUF, are also at risk from a setback in financial convergence expectations, as the lack of political
visibility in the Union could weaken the political commitment to speed up public finance reforms in the next couple of years. The near-term political agenda in Poland and the persistent twin deficits in Hungary would reinforce the negative impact on currencies.

Bond yield conundrum is back

The conundrum is back. Just two months ago, with US Treasury 10-year bond yields hovering around 4 per cent, Federal Reserve chairman Alan Greenspan wondered publicly why they were not higher. Investors took the hint and pushed yields rapidly up to 4.6 per cent. But the recent burst of risk aversion in the financial markets has sent 10-year yields back down again to 4.25 per cent.


Traditionally, bond yields have tended to rise during periods when the Fed is tightening monetary policy. However, 10-year yields are lower than when the Fed first raised rates in June 2004. The recent batch of weak economic data provides the rationale for the latest shift in yields. Treasury bonds have gained from their "safe haven" status at a time when investor sentiment seems suddenly to have deteriorated.

According to State Street, institutional investor confidence posted its biggest fall for 10 months in April; the poll was taken before last week's equity sell-off. The German ZEW survey of investor confidence, announced on Tuesday, fell more sharply than expected. The American Association of Individual Investors says that bullish investor sentiment has plunged to 16 per cent, its lowest level since September 1992.

All this must be a great disappointment to those pundits who predicted 10-year Treasury bond yields would hit 5 per cent by the end of this year. And it suggests that, for the moment at least, investors are ignoring two factors many believed would prove negative for bonds.
The first is that the US's heavy need for financing, thanks to its trade deficit, would eventually lead bondholders to demand higher yields. While the deficit is still getting wide, capital flows data indicate no shortage of future buyers.

The second factor is the threat of higher inflation. US producer prices rose 4.9 per cent in March while the most recent consumer inflation numbers showed a 3 per cent annual increase. But price pressures are much more subdued at the core level, which excludes volatile elements such as food and energy.

The lurking threat is stagflation, slower growth and higher prices. But the recent bond rally indicates that investors are not yet convinced this threat will materialise.