* Risks seen skewed towards flight to quality before EU
summitBy Emelia Sithole-Matarise and Kirsten DonovanLONDON, Oct 18 (Reuters) - The French risk premium over
benchmark German bonds hit a 19-year high on Tuesday after a
Moody’s warning on France’s rating outlook and as German bond
prices soared on ebbing hopes of a speedy solution to the euro
zone debt crisis.The cost of insuring French debt against default also rose
to near record highs after Moody’s said on Monday it may place
France’s triple-A rating on negative outlook in the next three
months if the country’s share of the cost of bailing out banks
and euro zone states stretch its budget too far.The warning, five days before a crucial EU summit, helped
push the 10-year French/Bund yield spread 18 basis
points wider to 114 bps, its widest since 1992.”For today, we’re probably seeing a bit of a knee-jerk
reaction as it is not new information, rather something the
market is becoming more aware of,” said WestLB rate strategist
Michael Leister.”But it can’t be argued away that any sort of expansion of
the (European rescue fund) or bank recapitalisation will result
in higher explicit liabilities for the French government.”Leister said a spread of 120-125 basis points over German
Bunds was quite possible for 10-year French bonds.Finance Minister Francois Baroin said France’s rating was
solid as Paris was taking steps to cut the deficit, though a
1.75 percent growth target by 2012 was probably too high.French bonds are likely to remain under pressure until a 9
billion euro sale of conventional and inflation-linked bonds on
Thursday, although take-up of the paper by primary dealers
should ensure a decent auction.”We’ve seen a bit of selling, but not enough to justify the
spread widening, the problem is more that there are no buyers,
one trader said.”France has always been a bit of a proxy for Germany if you
wanted some yield pick-up, but now there’s concerns about the
triple-A status and the ramifcations of them losing it.”The cost of insuring against a French default rose by 6,000
euros to 190,000 euros for an exposure of 10 million euros,
according to five-year credit default swaps data from Markit —
almost twice the costs of insuring triple-A-rated Dutch bonds.The French/Dutch 10-year yield spread was also
near its widest in 16 years at near 70 bps.VULNERABLERabobank strategists said they continued to play the risk of
a potential French ratings cut via a long position in Dutch
10-year bonds versus French debt.”We are mindful, however, of the sizeable imminent event
risk in the form of this weekend’s EU summit.”Bunds extended Monday’s gains as equities fell after the
Moody’s comments and data showing slowing Chinese economic
growth but trading was expected to be volatile before the
weekend European Union summitThe Bund future settled 96 ticks higher at 135.58,
having risen to a one-week high of 135.85 earlier, with
technical indicators pointing to more gains.”The nervousness is very high and negative comments will
have a larger impact than positive comments. The balance of risk
is we’re definitely going to see more positive performance in
Bunds,” Nordea analyst Niels From said.The contract tested support at 132.94 on Monday, the 38
percent retracement of the June-to-September bull trade, forming
a potentially bullish engulfing pattern.UBS technical analyst Richard Adcock had said in a note that
a settlement above the 134.80 opening price would open the door
for further gains.Cash 10-year Bunds yielded 2.01 percent , 8
bps less on the day, retreating from seven-week highs above 2.20
percent hit last week on market optimism the European summit
would unveil sweeping new crisis-fighting measures.Other lower-rated euro zone sovereigns underperformed
Germany. The Italian/German 10-year spread stood
at 386 bps, 15 bps wider than on Monday.
