French Bond Markets and AI Neoclouds Feel The Pressure

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0:18 Welcome to the Merlin Talks Money Market Wrap, where we talk about the biggest moves in markets this week and what's driving them. I'm John Stebic, senior reporter and author of the Mindstilled newsletter. I'm in today while Merlin's out. And joining me in the studio is one of our regular guests, Sam Unstead. Sam is the co-editor of Bloomberg's Markets Today blog, who have also launched a newsletter recently you should sign up for. And Sam writes about UK stocks, economics, central banks and global markets. Today, we're going to be talking about French bond yields, which have exploded higher. We're talking briefly about the UK and why we're currently somewhat in the good books for a change. And we'll also

0:58 be talking about AI and what's been going on with the latest wobbles in the art market. Sam, thanks very much for joining us again. It's nice to have you back on the show.

1:06 Thank you for having me.

1:08 So, I just wanted to warn our more sensitive readers that today you're going to hear the worst butchering of a foreign accent by a Scotsman since Sean Connery was in his prime. So, you know, just turn down the sound now, particularly if you're French, but I have to say zut alors and sacre bleu. What's been going on in the French bond market this week?

1:36 Well, nothing good. It has been a striking shift in the way that French assets in general actually are being looked at over the course of the last couple of months. So with the French debt situation and their political situation, This does come up, like this has happened previously, not to this extent, but pretty much every time they come round to what are we going to do about the deficit, you get a similar kind of bit of risk coming into French bonds. But those incidences have not been accompanied by an election next year. And so the political risk in France is now, I mean, really quite drastically high.

2:20 Yeah, because you look at the, just for clarity's sake, The way you measure this is a thing called LISPRED, which is the gap between the borrowing cost of French 10-year bonds and German 10-year bonds. And the highest that's ever been is just under 190 basis points. That's 1.9 percentage points. And today is back up at close to, not far off 1.8. So it got up to about 178 basis points then to today. And so that is, and that's the highest since the Eurozone financial crisis. So we really are talking about the kind of proper panic, aren't we?

2:58 Yeah.

2:59 It's a lot of panic, actually, but a lot of worry.

3:02 Yeah, yeah, yeah. We won't go all the way to panic just yet, although I think we're not that far off of that. But one thing that's very interesting about it is that when you look at your bond screens, which tend to have all of the European countries on them, For the most part this year, they generally have been moving in tandem because most of the movement has been based on oil prices and then onto interest rates and the curve for the European Central Bank. Now, you're looking at your screens and German yields today are down. They're actually falling by quite a bit. And French yields and Italian yields are going up. So there's a very specific narrative going on in European bond markets where investors are

3:38 assessing who they do and do not like. And actually, as somebody who works on a UK-focused blog, Gilt, which have been carrying the so-called moron premium for a while, and they still do, the gap between French yields and UK yields was, I think back in May, was about 150 basis points. Now it's about 30. So it's a huge change in where investor concerns about political risk, about government debt are being focused.

4:08 Yes, it's nice to be out of the spotlight from a UK point of view. I mean, you're right, I was looking at the spread between France and Britain and basically 10-year gilts haven't yielded less than French debt since 2013. But we're now only, like you say, about 30 basis, so 0.3% away. And so again, I mean, I guess that reflects, it doesn't just reflect France blowing up either. It's, you know, to be fair to our credit, the market seems to be giving the benefit of the doubt so far ahead of the budget next week.

4:46 Yes.

4:46 Which is interesting.

4:47 Yeah. If we do just briefly, yeah, on the UK and looking, you know, towards the budget next week, the thing that most investors seem to be kind of saying is that When Andy Burnham first came in, and previous to him coming in as well, there were concerns. The comments he made around finding flexibility in the fiscal rules, that caused a little bit of nervousness. Not as much as we've seen previously, but some. But they have been, Andy Burnham and also the Chancellor, John Healey, very, very clear.

5:21 And in fact, have probably said at this point, maybe a hundred times, we are going to stick to the fiscal rules. and we are going to find a way to do what we want to do without causing a huge upset in the bond market. Whether that happens or not, we shall see next week. But certainly most investors are just not that worried. They just feel as though it's going to be kind of okay. And that worry is just very, very much honing in on France. And then going out to the sort of weaker, if you like, parts of the Eurozone, as far as investors are concerned, and Italian bonds and you could feel a bit sorry for Italy in some ways, because they, in the past, were always BTPs, Italian government bonds, were the ones that

6:04 would have that kind of role that guilds had played for quite a long time, where guilds would sometimes just sort of sell off for almost no reason. That happened to Italy a lot, again, because of a lot of government change, which is, again, something we share with them. That's no longer been the case in Italy. Actually, they've been, for them, extremely stable politically over the course of the last couple of years. But because there's this concern in France...

6:25 That's spreading out to the rest of the Eurozone and it's dragging Italy along it.

6:28 It's interesting, isn't it? Because on the one hand, Britain obviously has had some economic growth, some kind of surprises to the upside, some figures that have kind of made the market feel more comfortable. But really, I think you'd probably have to argue that what's made the difference is that Healy and Burnham essentially speak in a more reassuring way than Stammer and Reeves did. And from that point of view, it is almost purely a kind of presentational political issue. I think the market probably feels that, okay, these guys broadly seem to be in charge. The party broadly seems to be behind them and they're roughly saying the right things. And we'll see if that comes to fruition at the budget, but there's that sense of kind

7:17 of confidence that, and it is in the politics. And I think what's interesting for, People have been in markets since, you know, whatever, the kind of 2000s and the 2010s. The assumption was mostly that politics didn't matter and it was kind of a side issue. And obviously this is, you know, very much demonstrated that it's not because ultimately the French thing boils down to it's not the fact that the debt is so high. It's the fact that there is nobody, essentially nobody in charge at the moment.

7:52 And we don't know who's going to be in charge in about a year. But it's going to be at least six to eight months before we actually have a clear view, won't it?

8:02 That is a really good point because, as I say, you're in a European debt market or a global debt market, really, or global government bond market, which, you know, for the first, maybe for the first time ever, really, is competing with a whole new set of potential investors. borrowers right from from the ai trade and and in all honesty like if you're sat there you know who do you want to to lend money to you've got france over here where as you just mentioned the politics is is a real mess at the moment and and the election is unlikely to clear any of that up so the political risk is really high or do you want to lend that money to microsoft to just throw off an enormous amount of cash and they're continuing to drive you know

8:40 kind of 25 percent growth so Where am I going to put that money? And obviously Microsoft don't need as much money as France does. But even so, within a market where there's this huge extra set of considerations to take as to who's in the market and there is only so much money to go around, if you have a political situation like that, anything you can use to kind of divide up, like who do you want to lend to and where is the weaker part of the market, investors will use it.

9:17 Rampant speculation time here just out of curiosity because obviously the spread is blowing out so that's the technical term for saying France is costing France a lot more to borrow than Germany there is an element of spillover into Italy as well which is arguably not entirely deserved and the European Central Bank at least part of its job is to keep an eye on these things Now, obviously, it would say at the moment, well, actually, we're only allowed to intervene to close the spreads if there's something irrational driving it. Whereas it's perfectly rational to want to charge France more to lend them money. At what point do you think the ECB starts to say, actually, there's a risk that this is existential for the euro? And

10:11 that kind of gives them permission at that point, doesn't it?

10:14 Yeah, I mean, I think we're quite a long way from that. Because I think... I need an exact spread number of some. If you look back to the Euro crisis... You know, nearly 15 years ago now. It's depressing, isn't it? But if you look back to that, the underlying issues, like in terms of the banking sector and stuff like that, was much more fraught and much more difficult than it is now. You know, everything now is much more regulated.

10:43 The financial system is much more robust.

10:46 This isn't about the banks. This is very much sovereign debt. So that's a good point.

10:52 And I think, yeah, so the spread is, you know, to Germany has gone out quite a bit. But the actual yield on French bonds, yes, is much higher than it was. But it's not at those kinds of levels where you would look at it and, you know, if you're invested in it, kind of start crying. Like, it's not that bad yet. And when you look at the yield, say the yield has closed against the UK, but it is still below. So we're not quite at that kind of, the word I think they would use is disorderly. We're not quite at that kind of point just yet.

11:22 I suppose my assumption is that we probably won't see anything until we do start getting headlines about the... You know, you get one big day where the euro suddenly craters by a percentage point against the dollar or even the pound or something like that.

11:37 Well, and there are also lots of other considerations to take into account over which Europe and the European Central Bank have no control whatsoever. You know, oil prices, for example, the AI trade, you know, and whether there's a bubble there, if that bubble bursts, you know, that kind of thing. There are lots of other things to take into account.

11:54 But I think we're a way off just yet.

11:56 See, that's a really interesting point then, Lois, turning to the AI and also the energy. But obviously, AI has had quite a few wobbly weeks, really. And every week seems to bring a sort of fresh bit just getting knocked out of the story. It's interesting because I hadn't really appreciated it, but whenever you start looking around the world...

12:20 A lot of these NEO clouds particularly are having either IPOs falling flat on their faces like in South Korea or in Australia. Obviously one completely failed to take off like the night before it was pulled. And I'm sure I saw another couple of kind of slightly smaller ones this week. Again, I think it was Australia where they've either come out and had to, I think one of them was failed to get kind of power connections for its data center, and the shares collapsed by about 40%.

12:51 Wow, so we can claim that one. Yeah, that's N scale in the UK.

12:54 Oh, yeah, well, I know that one, but there's another one as well. But yeah, the NEO cloud specifically seemed to be causing the angst this week.

13:03 Yeah, I mean, there's a corollary to draw with bond markets, which is that if you are starting to get a little concerned about how much money is being borrowed in the AI sector or industry or however you want to term it, You start to think about, okay, well, who do I want to lend to? And like I said, the hyperscalers, yes, they are spending an enormous amount of money, but they've got the money. And if they need to borrow some money, they can, because they generate huge amounts of cash, even with the capex that they're doing. The neoclouds are, in some respects, they're almost sort of startups, but really big startups or really valuable startups, because- they are, you know, highly leveraged to how everything goes. If, for example,

13:47 so the N scale thing was very interesting because, you know, that's a company that are trying to list, unfortunately in the US, they're a London or a UK based company. Yeah, yeah, yeah. But they've already had a bit of pushback on the valuation. So they've had quite a difficult, you know, week or two.

14:05 And then Microsoft pulling out of that data center, which I think was in Essex. I think it's the largest, data center project in the country in terms of the overall value of it, it leaves them in a difficult position because I think I remember this from the story this week, but the vast majority, more than 80% of their revenue comes purely from Microsoft and Anthropic. And so they are extremely leveraged businesses. So yeah, if you're looking around, where are you going to lend the money? You do need to, or who are you going to buy as a stock investor? You do need to have a think about where do I, if the cracks are going to appear, where are they going to appear first and it does seem that people are have decided neoclouds which is a

14:45 word that i don't think i ever thought would just enter my lexicon but now i'm saying it i've said it about six times now it.

14:49 Just trips off the tongue doesn't it well it seems just they're almost like these very leveraged slivers of data centers that are wedged in between the hyperscalers themselves and the like say anthropic and I mean, I guess if Trouble was going to show up, they are kind of obvious candidates because they're almost like a mortgage on a data center in terms of their kind of structure. Whereas, you know, at least Microsoft and Google, they're still Microsoft and Google and Anthropic and Chat or, you know, whatever they are. But they're not the same thing, is that?

15:27 No, no, not at all. I mean, in some respects, you haven't really seen companies like that, you know, these big tech companies really exist before, you know, in terms of just the sheer scale. I mean, maybe you go back to kind of the, you have to probably go back to the beginning of the 20th century for this kind of like enormousness of company. But for those, for the neoclouds in particular, you know, these are the companies that are in the midst of trying to IPO. A lot of them are trying to IPO. You mentioned Firmus, which is the, you know, the company in Australia who had to pull their IPO. And there was a big flop as well in South Korea.

15:57 Yeah.

15:58 They need those IPOs. You know, they need to raise that money because they need to shore up their balance sheet so they can continue this, you know, incredible amount of investing that needs to be done in order to meet the demands of the AI build-out. Which then, as you actually just mentioned as well, energy, just quickly as well, is then bumping up against the, you know, it's just, I would say, almost impossible to build enough energy capacity to actually connect all of these things to the grid as well. So then that creates delays and, These are all of the things that are starting to rumble like this question of, yes, there's hundreds of billions of dollars being spent on building out the AI, but can we

16:37 do it in the timescale that we think? You need copper, you need all these different commodities, you need to build out all these connectors to grids all over the world. And it's hard, complicated, long work. And so the speed it's all moved at, the neoclouds are the ones who are probably getting the first little bit of kind of pushback that maybe this has gone a bit too fast. Well, yeah.

16:59 And what I find really interesting is the AI bubble or whatever is kind of reminding me a lot of the commodity super cycle and the high prices are the cure for high prices. And so the high price of the chips means that people are starting to use the chips more efficiently. Because the other thing that has freaked people out slightly is this kind of meta kind of joint venture. Not so it's not a joint venture, but a tie up with Apple.

17:26 Yeah.

17:27 You can basically run Meta's AI agent Muse on Apple hardware. And it's not running on your local Mac. It's, you know, you'd still have to spend quite a lot. It's kind of a business thing rather than a consumer thing. But the point is that runs locally and you don't need the data center for as much stuff. And then there's that kind of question of, well, wait a minute, if you don't need as much data center capacity, then actually have we spent too much money on these things already?

17:57 Yeah.

17:57 So it's going to be interesting to see how that all plays out.

18:01 Yeah, because, I mean, if the answer to that ends up being no, then it kind of upends everything, you know, because... The amount of spending is truly, truly unbelievable. Not just on the most eye-opening, I suppose, is all the hyperscalers and the CapEx plans. But power companies, electricity companies, grid companies, miners who've got to get new mines going, which again is a long, difficult process. All of a sudden, they're all like, oh, hang on a minute. Do we continue with this? Do we pull back? Do we stop investing in this? it creates an enormous amount of uncertainty and markets really don't like uncertainty.

18:41 Yeah, it's always the problem with these kind of very capital intensive and long lead time projects is there's always a point at which someone's left hanging like, oh wait, I've only just opened this copper mine that you all needed 10 years ago and suddenly the price is down half. But anyway, that's such is life. Thanks very much, Sam.

19:00 Excellent to have you on again and have you on again soon, I'm sure.

19:04 You're welcome. Thank you very much for having me.

19:09 Thanks for listening to this week's Merrin Talks Money Markets Wrap. If you like our show, rate, review and subscribe wherever you listen to podcasts. And be sure to follow me on X at John underscore Stepek and Merrin at Merrin SW. This episode was produced by Summer Saadi, Moses Andem and Jennifer Seeley. Questions and comments on this show and all our shows are always welcome. Our show email is merrinmoney at bloomberg.net. Special thanks to Sam Unstead. Thank you.