French woes fuel contagion

THE euro could face further pressure in the weeks ahead as rising French borrowing costs threaten to spill into the wider eurozone, adding another headache for policymakers already grappling with higher energy-driven inflation and weak growth.

The single currency has already fallen to a 17-month low against several major currencies, and investors are increasingly watching whether political and fiscal concerns in France could turn into a broader European bond-market problem, according to a recent analysis by Reuters.

France is at the centre of the latest market anxiety as its government tries to push through an unpopular 2027 budget aimed at reducing the deficit and containing its record-high debt burden.

The challenge is particularly difficult with Parliament deeply divided and political factions positioning themselves ahead of next year’s presidential election.

Investors have responded by selling French government bonds while seeking the relative safety of German debt.

That has pushed the premium investors demand to hold French rather than German government bonds to its highest level since the 2010-2012 eurozone debt crisis, as Reuters highlighted.

The concern for the euro is that the French bond selloff may not remain a French problem.

“The bond selloff is seeing bigger moves in anything that is perceived in any way, shape, or form as more vulnerable, and that has seen an outbreak of euro selling that’s gathered momentum,” Societe Generale’s chief foreign-exchange (forex) strategist Kit Juckes told Reuters.

“The factors that held euro/dollar above key levels through the summer... I think that’s gone,” he said, pointing to earlier assumptions that the energy shock would be short-lived and that the United States would push for a weaker US dollar.

The scale of the bond-market moves is adding to the currency risk. The gap between French and German 10-year government bond yields recorded its biggest weekly jump in decades last week.

The spread between Italian and German yields also climbed to almost 130 basis points (bps), marking its biggest weekly increase since the Covid-19 crisis.

Source of vulnerability

For the euro, that means European developments are becoming a more important driver at a time when the currency has traditionally been more sensitive to movements in the US dollar.

“Euro/US dollar is usually influenced more from the US dollar side, but this time there is an impact from Europe too,” said Amundi Asset Management’s head of global forex Andreas Konig.

“You have to go back a bit in time to when European headlines last made the euro move,” he told Reuters.

The latest weakness is also different from the euro’s slide during the 2022 energy crisis, when Russia’s invasion of Ukraine sent energy prices soaring and pushed the currency to 20-year lows.

While the euro remains comfortably above those levels, the bond-market stress is creating a fresh source of vulnerability.

Every further 10-bps widening in the French spread against Germany would be associated with a 0.4% fall in euro/dollar, according to Bank of America forex strategists.

“The typical response is closer to zero most of the time, but (the spread impact) can rise significantly in times of acute stress,” Reuters quoted Goldman Sachs analysts as saying in a note.

“Spreads do not matter for the currency until they are the only thing that matters,” they said, adding that the impact on the euro becomes stronger when a risk event pushes German yields lower while yields elsewhere in the eurozone rise.

That pattern emerged last week, with Germany’s Bund yield falling almost 17 bps, its biggest weekly drop since 2024.

Konig does not see a medium-term turnaround for the euro and is maintaining a US dollar “overweight” position, citing the US growth and interest-rate outlook.

Breathing room

Market positioning is also pointing to further euro weakness. Commodity Futures Trading Commission data show traders positioned for a decline in the currency, while the options market is sending a similar signal, according to Reuters.

Three-month euro risk reversals, which measure the difference between the cost of options to buy and sell the euro, fell last Friday to their most bearish level since 2024.

Analysts see the euro potentially testing US$1.10, while Juckes also highlighted its vulnerability against the Japanese yen and Swiss franc. The euro fell almost 4% against the yen in September.

That puts the focus on whether policymakers may need to step in if bond-market pressure intensifies, particularly as France heads towards its 2027 election.

The European Central Bank (ECB) has a potential backstop through its Transmission Protection Instrument, which allows it to buy an unlimited amount of bonds from a country experiencing an “unwarranted, disorderly” tightening in financing conditions.

For now, however, there are some signs that the region’s economy is holding up. Eurozone business activity expanded at its fastest pace in nearly three-and-a-half years in September, according to S&P Global data.

That resilience could provide some breathing room, although the ability of banks to continue lending to companies and households will also be closely watched as borrowing costs rise.

The policy challenge could become more complicated if a weaker euro adds to imported inflation at the same time that higher bond yields increase financing costs.

“If the fiscal contagion risk in Europe is not contained, I can see euro/dollar trading lower, despite the fact that it was already slightly undervalued,” Stephen Jen, CEO and co-CIO of Eurizon SLJ Asset Management, told Reuters.