Why Bond Markets Are So Spooked by the French Election

The French bond market’s wobble this week brought echoes of the 2010-12 euro crisis. The euro fell 1.3% in two days, bond yields surged, and bank stocks plunged. It’s nothing like as bad as things were back then, but French President Emmanuel Macron’s surprise vote spooked investors.

The good news is that France isn’t in the same state as the financially stressed eurozone countries in 2010. They faced much bigger problems, which led to bond yields so high they created a doom loop between banks and government debt. Disaster, bailouts, bank failures and, in Greece’s case, default followed.

The bad news is that France’s situation is getting worse. It was downgraded by S&P Global last month because of the combination of high debt and persistent government deficits. It is likely to get a slap on the wrist from the European Commission next week for failing to rein in borrowing. If it chooses populists and still-more borrowing, markets could lose faith.

At the core of the problem: The French government and its voters don’t recognize that the country needs to do anything. They share the insouciance of Americans, where neither candidate for the presidency has any interest in bringing the deficit under control. Unlike the U.S., France doesn’t have the security of the world’s deepest bond market backed by the world’s reserve currency.

Contrast France with the countries that back in 2012 almost destroyed the euro. Greece, Portugal and Ireland are now running government surpluses before interest costs, unlike the rest of Europe. Spain is running a current-account surplus, reversing a reliance on foreign financial inflows that once threatened to destroy its banks. All have pushed through politically painful reforms of their economies and are growing nicely.

True, it was a long and difficult process, to put it mildly. The periphery countries were living beyond their means, and bringing their economies back into balance wasn’t easy—either financially or politically. Italy, which was late to hit trouble, still hasn’t learned the lesson and has been spending as freely as France, though it is helped by support from Europe.

The risk is that France needs a shock to understand that it needs to change. Macron has been flouting the (admittedly dumb) European rules on deficits, expecting to spend 5.1% of gross domestic product more than his government raises this year. Marine Le Pen’s National Rally, run by the former presidential candidate’s protégé, Jordan Bardella, has plans to spend still more while being even less likely to listen to the scolds at the European Commission.

French voters should look across the English Channel to see what could happen if they ignore the markets. In 2022, sterling and gilts, British government bonds, offered a clear warning to the U.K.’s ruling Conservative Party that if they followed the policies pushed by Liz Truss during her campaign to be leader, it wouldn’t go well. When she became prime minister and tried to bring in unfunded tax cuts, investors fled, bond yields and mortgage rates soared and a nasty feedback loop between yields and pension funds threatened the financial system.

In France’s case, the potential feedback loop is with the banking system, by far the largest in the euro area. If government bond yields jump, banks suffer, as their shares did this week. If things get bad enough, fears of the cost of bank rescues push up bond yields, which makes the bank situation worse. The French should avoid this at all costs.

It remains unclear whether French voters are ready to consider themselves as living in a financially vulnerable country. But the markets have already spoken: French 10-year bonds this week yielded more than Portugal and have almost caught up with Spain.

Sure, Portugal and Spain aren’t the bywords for financial mismanagement they once were, and France is in a much better state than Italy. But the French self-image needs to change. It doesn’t belong in the safe-bond zone with Germanic northern countries anymore. It has joined its Mediterranean cousins with more debt and persistent big deficits—and that requires both politicians and voters to understand the importance of keeping the bond markets on its side.

Write to James Mackintosh at james.mackintosh@wsj.com