Some hedge funds are calling it quits on one of their biggest trades of the year - shorting French government bonds.
Earlier this year many in London's hedge fund industry were lining up bets against the euro zone's second-largest economy, reckoning the May election of President Francois Hollande, a socialist, would accelerate the country's deteriorating economic outlook.
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But the trade has not worked out as planned. France's long-term borrowing costs fell to a record low at auction last week as investors sought out safe havens. So some funds are now cutting their losses or changing tactics, for instance betting against French equities instead.
"It's a slow burner," said one hedge fund manager who was short French bonds earlier but has since exited the trade. He asked not to be named. "I think people are too early."
Shorting is a bet that the price of a security will fall.
With a few exceptions - notably a strong rebound in early June - French 10-year yields have been on a downward path for much of this year, and on Thursday stood below 2 percent. Core German 10-year yields, in comparison, are now around 1.32 percent.
Pedro de Noronha, managing partner at London-based Noster Capital, was shorting French government bonds earlier this year and offsetting them with high-yield senior secured corporate bonds. He told Reuters this month he has since closed the trade to take what profits were forthcoming from the two-way deal.
"I don't think anyone wants to be (short)," said Andrew McCaffery, global head of hedge funds at Aberdeen Asset Management. "Most participants are taking a more sanguine short-to-medium-term view because of the ECB."
The European Central Bank promised in September to do what it takes to protect the euro zone, including buying struggling debt if necessary.
Earlier this year some hedge funds - who have been accused by politicians of exacerbating euro zone debt woes by betting against the bonds - were pointing at some of Hollande's more controversial policies as likely drivers of a sell-off in bonds.
They focused on tax hikes for the rich and cuts to the pension age for some workers, which they believed would further hit France's competitiveness. They have also focused on the loss of France's prized AAA Standard & Poor's rating in January, unemployment rates now at a 13-year high and a debt to GDP ratio of around 90 percent.
Their concerns were encapsulated by The Economist, which last month called France 'the time-bomb at the heart of Europe' on its front page. French officials accused the British-based weekly of sensationalism.
Not everyone has taken off their bets. Patrick Armstrong, head of investment selection at Armstrong Investment Managers, began shorting 10-year bonds at yields of 2.2 percent and is holding on to his position. He says 10-year bond yields have historically been around inflation plus 1 percent, equating to yields of about 2.9 percent.
But many funds are now more fearful that other factors could derail the trade, eroding their already meager profits for 2012.
The average fund is up 4.9 percent in the first 11 months of the year - less than they lost last year but well behind a 14.9 percent total return from the S&P stock index .
Managers now see the ECB's September announcement as a game-changer that could work against them.
"(France is) systemically important, and there may be intervention if it ever gets to the point where it's at risk," said Louis Gargour, chief investment officer at LNG Capital.
He said that shorting France using 10-year CDS (credit default swaps) had "gone horribly wrong for people who were short" and added: "The trade on fundamentals makes sense, but in terms of technicals and regulatory hurdles it may hurt you."
Funds also point to the weight of investors seeking refuge in French bonds, or the possibility that liquidity could dry up.
"Even if being short French government bonds seems an obvious trade, I would not implement it," Philippe Gougenheim, chief executive of Gougenheim Investments, told Reuters.
"I am paranoid about liquidity, and I do not want to enter into any trade on a market where liquidity can dry up very quickly. It never happened on French govvies (government bonds), but did take place on Italian ones in '08 and '09."
Gougenheim also pointed to French life insurance purchases of bonds and the large euro reserves of central banks around the world sitting in French and German bonds, which he thinks unlikely to be sold.
Rather than use bonds, he is short a basket of stocks - including many French companies - with a large exposure to both high labor costs in Europe and depressed European consumers. He has offset this by buying another European stock index, he said.
(Editing by Jeremy Gaunt)