Euro sinks to 17-month low as French debt fears spread

The euro has reached a 17-month low, dropping below $1.12, as concerns over French borrowing costs ripple through the broader euro area. The French government's push to reduce its deficit and manage high debt amid political divisions has spooked investors, who are selling French bonds and buying safer German debt. The premium on French bonds compared to German bonds has hit its highest level since the euro zone debt crisis of 2010-2012, raising fears of contagion.

Political uncertainty across Europe is adding to the instability. Germany's Chancellor Friedrich Merz's party recently suffered a major defeat, Spain's Prime Minister Pedro Sanchez has called a snap election, and Italy is also facing elections next year. Rising inflation and higher borrowing costs for households and corporations are further straining the economy, leaving the European Central Bank in a tough spot between controlling inflation and stabilizing bond markets.

The gap between French and German 10-year bond yields saw its largest weekly jump in decades, while the spread between Italian and German yields reached nearly 130 basis points, marking the biggest rise since the COVID-19 crisis. Analysts warn that every 10 basis point increase in the French-German bond spread could lead to a 0.4% drop in the euro-dollar exchange rate. The euro's weakness is being driven by both European factors and the stronger dollar, a shift from earlier assumptions of a short-lived energy shock.

Traders are positioning for further declines in the euro, with options markets showing the most bearish sentiment since 2024. Analysts predict the euro could test $1.10, with vulnerabilities also seen against the yen and Swiss franc. The euro fell almost 4% against the yen in September. With economic growth already weak, the risk of fiscal contagion in Europe could push the euro even lower.