By Yoruk Bahceli and Dhara Ranasinghe
(Reuters) -As the far right and leftist parties gain momentum ahead of France's surprise parliamentary election, investors are starting to contemplate the risk of a budget crisis at the heart of the euro zone.
Marine Le Pen's far-right National Rally party (RN) is leading in opinion polls ahead of the ballot called by President Emmanuel Macron for June 30 and July 7, albeit unlikely to win an absolute majority.
Although it has not yet announced its detailed programme, the RN has previously favoured lowering the retirement age, tax cuts and boosting spending.
That has exacerbated concerns about fiscal sustainability in the euro zone's second largest economy just weeks after France's high deficit led to a credit rating cut.
A newly formed leftist alliance meanwhile said on Friday it wanted to lower the retirement age and tie salaries to inflation, adding to expectations for higher spending under a new government. Polls show the leftist parties coming second behind the RN.
Investor reaction was blunt: the risk premium they demand to hold French government bonds over euro zone benchmark Germany rose to the highest since 2017 on Friday at 82 basis points, its biggest weekly jump since at least 2010, according to LSEG data.
On Monday it dropped to 75 bps as markets calmed, but was still over 25 bps higher than before the election announcement.
"The focus has shifted back to the scope for some kind of near term crisis," said Gordon Shannon, portfolio manager at TwentyFour Asset Management.
"You're pricing the risk that you have an event similar to the UK's mini budget," he said, referring to Britain's then-Prime Minister Liz Truss' mini-budget of unfunded tax cuts in 2022 that pummelled gilts and forced the Bank of England to step in to stabilise markets.
Finance Minister Bruno Le Maire, urging voters to back Macron's centrist candidates, warned on Friday of the risk of a financial crisis if either the far right or the left wins the election.
The cost of insuring France's debt against default jumped on Friday to its highest level since May 2020, while the spillover of rising borrowing costs has knocked banks.
Shares in the country's biggest three - BNP Paribas (OTC:BNPQY), Credit Agricole (OTC:CRARY) and Societe Generale (OTC:SCGLY) - struggled to recover on Monday after losing between 11-15% last week, the most since March 2023's banking crisis.
But the European Central Bank's chief economist Philip Lane on Monday downplayed any need for the ECB to come to France's rescue by buying bonds, saying the market moves were not disorderly, a condition for ECB intervention.
ECB sources had earlier told Reuters policymakers had no plan to discuss emergency purchases of French bonds and thought it is for French politicians to reassure spooked investors.
The ECB's backstop tool to buy government bonds if warranted requires compliance with parameters like the EU's fiscal rules to limit budget deficits.
EURO ZONE RECKONING?
Demonstrating how market ructions are already hitting funding plans, a French state-backed agency cancelled a bond sale and France's treasury plans to raise a smaller amount than usual at a bond auction this week.
Bond investors are often dubbed vigilantes by analysts for demanding higher returns from governments they perceive as fiscally reckless.
"We've already had a stress test in the UK with the mini budget and we had a bit last summer in the U.S. when Treasury yields rose sharply after the Treasury refunding announcement," said Guillermo Felices, global investment strategist at PGIM Fixed Income.
"We haven't had this yet in the euro zone."
The Institut Montaigne think tank has said the RN's programme for the 2022 parliamentary election would cost more than 100 billion euros -- suggesting a 3.5 percentage-point increase in France's budget deficit -- if fully enacted. That's much higher than estimates for Truss's tax cuts.
RN President Jordan Bardella said on Friday that the party would detail its platform in the coming days and how it would be financed. It has so far been vague about where it stands on fiscal responsibility, other than blaming the outgoing government for straining the public finances.
"In an extreme case, the risks could include a Liz-Truss-style blowout in yield spreads," Holger Schmieding, chief economist at private bank Berenberg, said earlier this week.
Britain's 10-year yield jumped over 100 bps in less than a week during its budget crisis.
There were some early signs that concern over France might spread in the euro zone.
Italy's closely-watched risk premium over Germany rose to the highest since February at 159 bps on Friday.
Italy last year posted the highest budget deficit-to-GDP ratio in the European Union, at 7.4% of output. Together with France, it is expected to face a European Union excessive deficit procedure requiring it to reduce its structural deficit.
The euro hit a 1-1/2-month low against the dollar on Friday and euro zone bank stocks fell 8% last week.
Others said it had yet to be seen how a potential government that included the RN would act in office. Italy's debt outperformed last year, helped by far right Prime Minister Giorgia Meloni moderating her tone in office.
Iain Stealey, international chief investment officer for fixed income at JPMorgan Asset Management, said the RN's spending plans would be curbed by the EU's deficit rules.
"The market will also be a key force in keeping National Rally in check, with the party likely to take a more prudent fiscal stance ahead of the 2027 presidential election," he added.