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French markets ride high on political progress

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Investor focus remains on fiscal outlook

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Suspension of pension reform a longer term concern

By Alun John, Dhara Ranasinghe and Stefano Rebaudo

LONDON, Oct 15 (Reuters) - France's financial markets

are riding a roller-coaster as the country grapples with one of

its worst political crises in decades, and while sentiment is

improving, the bumpy ride is not over.

French Prime Minister Sebastien Lecornu has promised to suspend

a landmark pension reform until after the 2027 election,

sacrificing one of President Emmanuel Macron's achievements to

ensure the government's survival.

Here's a look at where markets stand, and what comes next.

BOND VIGILANTES IN HIDING?

The gap between 10-year French and German bond yields, the

premium investors require to lend to France, is around 78 basis

points, down from almost 90 bps last week.

It could tighten towards 75 bps, said Citi's senior rate

strategist Aman Bansal.

It narrowed as investors focused on political stability over

long-term fiscal worries. Lecornu's plan to suspend pension

reform means he'll likely stay in his job, avoiding snap

elections, even if some parties have called a no-confidence vote

for Thursday.

RBC BlueBay Asset Management senior portfolio manager Kaspar

Hense said the firm had closed out of its short position - a bet

on price falls - in French bonds last week on expectations a

political compromise would be found.

"Demand for OATs (French bonds) remains strong at these

levels of real and nominal yields," said Reinout De Bock, head

of European rate strategy at UBS.

RATINGS WATCH

French borrowing costs remain among the highest in the euro

zone, and because suspending the key pension reforms keeps

pressure on public finances, France is vulnerable to further

ratings downgrades.

Lecornu says the suspension would cost 400 million euros

($463 million) in 2026 and 1.8 billion euros in 2027. Without

offsetting measures, France's debt-to-GDP ratio would fail to

stabilise, analysts say.

Goldman Sachs reckons permanent suspension of the pension reform

would add 0.5% of GDP to the deficit by 2035, so debt as a share

of GDP over the next decade stabilises closer to 130% compared

to around 113% now.

Moody's, which rates France at Aa3 with a stable outlook,

reviews France on October 24.

"We expect some downgrade pressure but this is priced in by

markets," said BlueBay's Hense.

STOCKS SOAR

France's blue chip share index rose 2.6% on Wednesday,

set for its best day since April's tariff bounceback, but that's

not much to do with politics -- luxury giant LVMH

surged 14% after results.

French midcaps are up around 1% but have

underperformed longer term, up nearly 10% in the past two years,

compared to 15% for the blue chip index, and 26% for the overall

European benchmark.

And that could continue.

Claudia Panseri, chief investment officer at UBS Wealth

Management France, said that even if politics stabilises, fiscal

and political challenges would still hang over domestic stocks.

"European investors may prefer to focus on more

internationally diversified companies within the CAC 40, which

are less exposed to domestic risks," she said.

BANKS BOUNCE BACK

But politics does matter for French banks.

"Banks have been the most sensitive sector to the political

situation in France, and the most (bond) spread sensitive as

well," said Barclays head of European equities strategy Emmanuel

Cau.

Higher spreads typically mean higher wholesale funding costs

for banks, hurting profits.

Societe Generale, BNP Paribas and Credit

Agricole shares jumped over 2% each on Wednesday,

having underperformed other European banks and broader French

stocks last week when Lecornu stepped down.

Societe Generale's share price has doubled this year and any

underperformance in banks may present a buying opportunity.

EURO RECOVERS FROM A COLD

A stellar euro rally has been dented by the political

turmoil and it too is expected to benefit from stability.

ING currency strategist Francesco Pesole said the euro was

looking less "fragile" with the French/German bond spread below

80 bps, adding he was watching no-confidence motions.

"If Lecornu survives the no-confidence vote, euro/dollar

could edge higher and potentially build strong support around

$1.160," he said. It's trading around $1.1627, up 12%

this year.

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