French President Francois Hollande's honeymoon with bondinvestors may be ending as economic reality bites.

Hollande, who returned from a 15-day summer break last week,faces an economy that hasn't grown in three quarters, risingjoblessness, a ballooning trade deficit and the task of coming upwith a plan in the next few weeks to plug a budget hole of morethan 30 billion euros ($37 billion) for next year.

The challenges ahead may undermine the rally in French bondsthat has allowed the country to sell bills at negative yields forthe first time. During Hollande's first 100 days in office, thepremium demanded to hold French 10-year debt rather than comparableGerman securities fell to the lowest in more than a year. Thattrend may be reversing.

“France's fundamentals — rising unemployment, widening currentaccount deficit and budget deficit — would not support its bonds,”said Jamie Stuttard, head of international bond investments atFidelity Investments in London, which has $1.6 trillion undermanagement. “The more expensive French bonds go, the harder thecase becomes for French government debt.”

The French 10-year yield is at 2.06 percent, near the record-lowof 2 percent reached on Aug. 3 and down from 2.89 percent on thelast trading day before Hollande's election on May 6. While thepremium France pays over Germany to borrow for a decade fell below60 basis points for the first time in more than a year on Aug. 15,it's rising again. It was 73 basis points today.

French government securities returned 0.34 percent this monthafter earning investors 3.98 percent in July, trailing bonds fromBelgium, Ireland and Portugal, according to Bank of America MerrillLynch data.

Sovereign debt from France, which was stripped of its AAA ratingby Standard & Poor's in January, got more expensive throughout2012 — notably since Hollande's victory. The rally came as theEuropean Central Bank cut its main interest rate to a record lowand reduced its deposit rate to zero as the euro area teetered onthe verge of recession and Spanish and Italian 10-year bond yieldsclimbed above 6 percent.

Investors were lured by France's stability relative to Europe'sso-called periphery and by Hollande's consistent reiteration of hisgoal to cut the budget deficit to 4.5 percent of gross domesticproduct this year and 3 percent next year from 5.2 percent in2011.

Sliding Returns

French debt is “rich relative to fundamentals,” said PadhraicGarvey, head of developed markets debt strategy at ING Bank NV inAmsterdam. “The spread is vulnerable if we have a re-ignition ofperipheral scares in coming weeks or months.”

Hollande wants to counter that possibility by moving quickly tobolster Europe's crisis-fighting toolbox. Meeting with ChancellorAngela Merkel in Berlin Aug. 23, he said he wants euro nations tomove as fast as possible to implement the terms of a June agreementon a banking union and the use of bailout funds to restoreconfidence and bolster growth.

Whether or not European leaders manage to reassure investors,Hollande also knows he has an uphill task ahead at home. Accordingto the national auditor, he will have to find about 33 billioneuros in new tax revenue or savings by the time his government setsout its 2013 budget on Sept. 24.

The budget hole will be larger if the finance ministry is forcedto lower its 2013 growth forecast of 1.2 percent. That's lookinglikely after France posted a third consecutive quarter withoutexpansion in the three months through June.

French jobless claims rose to the highest in 13 years in July asstalling growth prompted companies to trim payrolls, a LaborMinistry report yesterday showed.

Prime Minister Jean-Marc Ayrault declined to repeat next year'sgrowth forecast in a radio interview on Aug. 22.

“I don't think anyone bought French bonds without being aware ofthe risks and challenges France is facing,” said David Schnautz, afixed-income strategist at Commerzbank AG in New York. “But becausethe country's fundamentals are deteriorating, the biggest risk isthat it may not be too difficult to find a trigger that would makeinvestors feel the need to re-price French bonds.”

Reviving growth means that Hollande also has to tackle laborcosts that are among the highest in the euro area, leading to arecord trade deficit last year and tens of thousands of job cuts atcompanies ranging from PSA Peugeot Citroen SA to drug maker SanofiSA and Air France-KLM Group.

Losing Confidence

For the first time since Hollande took office on May 15, amajority of French voters lack confidence in his ability to runFrance, pollster CSA said Aug. 23.

Only 49 percent of the French said Hollande has the capabilitiesto steer the country, down from 58 percent in May, according to theCSA poll for Les Echos newspaper carried out Aug. 21 and 22. Hispredecessor Nicolas Sarkozy had a rating of 55 percent at thethree-month mark in 2007.

For bond investors, the biggest concern is that with Frenchborrowing costs still among Europe's lowest, Hollande may put off amuch-needed overhaul of the country's economy in the face ofpopular discontent.

Hollande “needs to prepare the ground,” said Nicholas Spiro ofSpiro Sovereign Strategy in London. “The problem is that he's boxedhimself in politically. The only force that will compel him tocarry out meaningful reforms is market pressure.”

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