Euro Slumps as French Bond Fears Spread Contagion
The euro has hit 17-month lows, slipping below $1.12 and weakening against other major currencies, as concerns over French bond markets spread across the eurozone. At the center of the turmoil is France's struggle to pass a 2027 budget aimed at reducing its deficit and managing its high debt levels, a challenge complicated by political divisions ahead of next year's presidential election. Investors are selling French bonds and buying safer German debt, pushing the premium on French bonds over German ones to its highest level since the eurozone debt crisis of 2010-2012. This has raised fears of contagion, further weakening the euro amid a backdrop of political uncertainty across Europe.
Political instability is adding to the economic pressures. Germany's Chancellor Friedrich Merz's party recently suffered a significant regional election defeat, while Spain's Prime Minister Pedro Sanchez has called a snap election. Italy is also set to hold elections next year. Rising inflation due to soaring energy costs and higher borrowing costs for households and corporations are making the situation more precarious. The European Central Bank (ECB) faces a tough choice between fighting inflation and stabilizing bond markets, as further euro weakness could exacerbate these challenges.
Analysts note that the bond sell-off is intensifying pressure on vulnerable markets, leading to a surge in euro selling. The gap between French and German bond yields saw its biggest weekly jump in decades, with the spread reaching nearly 130 basis points. Every additional 10 basis points increase in this spread is estimated to cause a 0.4% drop in the euro-dollar exchange rate. Currency traders are positioning for further euro declines, with options data reflecting a bearish outlook. Some analysts predict the euro could test $1.10, with vulnerabilities also evident against currencies like the yen and Swiss franc.
Despite these challenges, there are signs of economic resilience. Eurozone business activity expanded at its fastest pace in nearly 3.5 years in September, according to S&P Global data. However, the extent to which banks can continue lending to support economic growth remains a critical factor. If fiscal contagion risks are not contained, particularly with France's upcoming elections, the euro could face further downward pressure. The ECB's Transmission Protection Instrument, which allows unlimited bond purchases to stabilize markets, may be called upon if conditions worsen.