‘Tide Turning’ Against France, Say Economists
As France loses its coveted AAA-rating, economists are questioning whether the tide is turning for a country that has enjoyed record low borrowing costs, and indeed whether the second largest economy in the euro zone is in jeopardy.
"The tide is turning for France. Although the country's bond market is likely to remain resilient — the yield on 10-year paper is little changed [Tuesday] morning and still stands a whisker above its record low of 2.06 percent on July 19 — French debt looks more and more overvalued relative to fundamentals," Nicholas Spiro, Managing Director of Spiro Sovereign Strategy, said in a note on Tuesday.
France has enjoyed low borrowing costs as investors have viewed the country as a safe haven in comparison with its southern European cousins.
The downgrade of France to AA1 with a negative outlook by Moody's has thrown its "deteriorating fundamentals….into sharp relief" Spiro said.
(Read More: Risk is Back in France)
Last week, France's latest gross domestic product (GDP) data revealed a better than expected 0.2 percent growth in the third quarter, quashing fears that the economy would enter a recession by year end.
But economists at Citigroup and Credit Suisse issued reports on Tuesday warning investors to beware of false friends in the seemingly positive data, and like Moody's, cautioned that a lack of competitiveness and growth in France could damage the country's economic recovery.
"Given persistent downside risks to economic activity, we continue to forecast a mild GDP contraction of 0.2% in 2013. With the 3 percent of GDP budget deficit target likely to be missed," Guillaume Menuet of Citigroup wrote.
The growing concerns about Europe's second-largest economy were heightened last week after The Economist called the country a ticking time bomb at the heart of the euro zone, drawing the ire of France's politicians.
(Read More: Cracks in France...as Southern Europe Goes Ahead)
Depicting a bunch of baguettes like dynamite strapped with the French flag, with a lit fuse on the front cover of its latest issue, The Economist warned that France's lack of reforms would come back to haunt the country as it repelled investors and drove up the unemployment rate from the 10.8 percent currently.
France's Fall From Grace Expected
Paul Day, Chief Strategist at Market Securities, told CNBC that although The Economist' cover design was a little "sensationalist," France could be the next candidate to combust in the euro zone, even as worries grow about European powerhouse Germany's apparent economic deterioration.
"I do think the Economist is correct in its assertion that, of the two countries at the heart of the euro project, baguettes would appear eminently more combustible than bratwurst at this juncture," he said, agreeing with Citi and Credit Suisse that France was likely to miss its 3 percent budget deficit target in 2013.
However, Day added that France was more likely to suffer due to the exposure of its banks to peripheral contagion rather than a malaise from within.
"The main risk comes from exogenous contagion effects rather than a domestic slowdown in isolation [as the Economist suggested in its feature]," Day added.
"France would not be the first domino to fall, but it is a bloody big baguette shaped domino, that looks quite precarious if others start to topple. In that regard, the Economist may end up being right, but for the wrong reasons."
Despite all the gloom and doom, French government bonds have rallied and yields have fallen. On Thursday, France sold 8.8 billion euros ($11.3 billion) of securities at record-low yields. The two-year securities were sold at a record-low yield of 0.1 percent, down from 0.19 percent at the previous auction on October 18. The five-year notes were sold at an all-time low and ten-year bond yields declined two basis points to 2.08 percent.
"We have long argued that French yields remain one of the most conspicuous anomalies in the European sovereign credit landscape," Nicholas Spiro said.
"This is due entirely to the idiosyncrasies of France's government bond market: deep enough, liquid enough and relatively safe enough to act as a 'second-best' alternative to even richer German paper."
Bond yields may have also gotten a boost from an unlikely quarter — the Swiss Central Bank has been reportedly buying safe-haven euro zone debt, such as that of France, Germany and the Netherlands in its attempt to weaken the Swiss franc against the euro .
Padhraic Garvey, Global Head of Rates Strategy at ING told CNBC that French bond yields had been defying market logic and falling despite economic concerns.
"The French fundamentals aren't fantastic," Garvey told CNBC Europe's "Squawk Box" on Friday, before Moody's downgrade.
"[But] it has a strong credit [status] — it might not be triple A in most people's eyes but it's still our top-rated credit."
"Fundamentally, France has problems but we should bear in mind that French yields in absolute terms have hit an all — time low this week, along with Belgium, and both of those issuers were under remarkable pressure this time last year," Garvey said.
But Nicholas Spiro warned that the bond market rally wouldn't last.
"The rally is overdone and the odds of a correction — the severity of which will depend largely on the external environment — are growing by the day," he said.