Euro, European bonds unnerved by French politics

[February 07, 2017]  By Jamie McGeever

LONDON (Reuters) - The increasingly unpredictable French presidential election race unnerved European financial markets on Tuesday, tipping the euro towards its biggest fall this year and driving investors away from French government bonds.

The premium investors demand for buying French 10-year government bonds <FR10YT=TWEB> over German 10-year bonds <DE10YT=TWEB> rose to 78 basis points, the highest level since November 2012 before easing back a bit. It was 50 basis points only two weeks ago.

The dollar recovered from earlier losses to register its biggest gain of 2017 against a basket of major currencies, jumping against the offshore Chinese yuan after Beijing's foreign exchange reserves fell below $3 trillion for the first time in six years.

European corporate earnings offered investors some cheer - even though oil giant BP <BP.L> missed estimates - helping to steer U.S. futures into positive territory. Wall Street was looked set to rise 0.3 percent at the open <ESc1>.

European trading, however, was dominated by the latest twists in the French presidential election race, while doubts over a rescue package for Greece also stoked concerns over the future stability of the euro zone.

"It is clear the euro is vulnerable to political uncertainty," Rabobank analysts said on Tuesday.

"Although opinion polls suggest that (Far-right National Front Leader Marine) Le Pen will not win the second round of the French presidential election in May, polls have wrongly picked the winners of both socialist and republican primaries," they added.

Le Pen has vowed to fight globalization and take France out of the euro zone.

The election is being stirred by controversy. Conservative candidate Francois Fillon has vowed to fight on for the presidency despite a damaging scandal involving taxpayer-funded payments to his wife.

Emmanuel Macron, the independent centrist candidate and current favorite to win the election, on Tuesday knocked down rumors he has a gay relationship outside his marriage since 2007.

The euro fell 0.8 percent to $1.0665 <EUR=>, its biggest fall since Dec. 15 last year, while the dollar index was up 0.7 percent, its biggest rise since Jan. 6 <.DXY>.

The spread between Italian <IT10YT=TWEB> and German bonds meanwhile widened to 202 basis points, the highest in three years, while the Portuguese-German spread hit 390 basis points for the first time in three years also <PT10YT=TWEB>.

The spreads narrowed a bit by the European mid-day.

"The acceleration of the trend of wider spreads since the start of the year has been widespread and not just confined to France, where obviously the political ... risk is the greatest," said Kenneth Broux, head of corporate research, FX and rates at Societe Generale.

Investors initially sought the safety of U.S. Treasury and German debt, but selling pressure mounted as stocks moved further into positive territory. The dollar's rise dulled the allure of gold, the traditional safe-haven asset in times of political and economic uncertainty.

Traders work at their desks in front of the German share price index, DAX board, at the stock exchange in Frankfurt, Germany, February 1, 2017. REUTERS/Staff/Remote

The yield on 10-year U.S. Treasuries hit a two-week low of 2.40 percent before recovering to 2.43 percent <US10YT=RR>.

BELOW $3 TRILLION

European stocks extended gains, with the FTSEuroFirst 300 index of leading shares up 0.5 percent in early trade at 1435 points <.FTEU3>.

Chipmaker AMS <AMS.S> rose 16 percent, poised for its best-day ever after the company's fourth-quarter revenue came in at the top end of the chipmaker's expectations. BP was the biggest drag on the broader index, down 2.5 percent.

MSCI's broadest index of Asia-Pacific shares outside Japan <.MIAPJ0000PUS> fell 0.3 percent, while Japan's Nikkei <.N225> closed down 0.35 percent.

Data on Tuesday showed that Chinese FX reserves fell for the seventh straight month in January and below $3 trillion for the first time in six years.

The dollar rose 0.5 percent against the offshore yuan <CNH=>, its biggest rise in three weeks. Concerns remain over the speed at which China has depleted its cash resources to defend the currency. Reserves were almost $4 trillion in 2014.

"The underlying pace of decline in FX reserves was $40 billion in January (vs a drop of $29 billion in December), suggesting that capital outflows have accelerated despite tighter capital control measures implemented in late November," Morgan Stanley said in a note on Tuesday.

Oil prices buckled under the dollar's gains, extending their decline following the biggest one-day loss since Jan. 18 on Monday as worries about rising oil supply out of the United States tussled with optimism about output curbs elsewhere.

U.S. crude <CLc1> fell 0.3 percent to $52.86 a barrel, after falling 1.5 percent on Monday. Brent <LCOc1> fell 0.2 percent to $55.59, after sliding 1.9 percent on Monday.

Gold fell 0.5 percent to $1,229 an ounce <XAU=>, after hitting a three-month high on Monday.

(Reporting by Jamie McGeever; Editing by Jeremy Gaunt)

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