Euro Weakens as French Political Uncertainty Limits ECB Options

The euro has weakened significantly in recent weeks due to the rapid rise in French government bond yields, creating challenges for the European Central Bank (ECB) as it addresses inflation, which hit 3.8 percent in September. The euro dropped to around 1.12 dollars, its lowest level since May 2025, and also lost ground against the Swiss franc and the pound. The spread between French and German 10-year bonds exceeded 150 basis points on Friday, the highest since 2011, as France struggles to pass its 2027 budget, which aims to reduce the deficit to at least 5 percent.

The uncertainty in France has raised concerns about contagion spreading to other heavily indebted countries, with Belgian, Greek, and Italian bonds already under pressure. In Italy, the spread on BTPs has risen by around 30 points in recent months. Meanwhile, Spain's snap election, called by Prime Minister Pedro Sánchez, had little impact on the markets as it had already been anticipated.

The ECB faces a dilemma over whether to use the Transmission Protection Instrument (TPI), created in 2022 to buy bonds when yields rise in an ‘unjustified and disorderly’ manner. Buying French bonds would lower yields and ease borrowing, but this contradicts the ECB's monetary policy since June, when it raised interest rates for the first time since September 2023. France's rising yields are due to political irresponsibility rather than irrational market turmoil, making it unlikely to meet TPI criteria.

Inflation and debt continue to weigh on European stock markets, with the Stoxx Europe 600 index recording its fourth fall in the last five weeks. Europe is now grappling with a multitude of crises, including political, energy, housing, debt, and inflation challenges.