Eurozone Spillover: French-German Spread Hits 130bp, EUR/USD Declines

The eurozone's fiscal troubles may only be starting to manifest, as FX spillover from France begins to take hold. The French-German 10-year spread has reached 130bp, causing both EUR/USD and EUR/CHF to decline.

ING analysts believe the recent budget announcement in France buys some time but fails to address structural deficit issues. With no party having presented a detailed spending cut plan, upcoming elections are adding to uncertainty. The rates team at ING predicts that 150bp may be the next step for the 10yr OAT-Bund spread.

This creates significant downside risks for the euro. Rising yield volatility and wider spreads are pushing the market back into an environment where the euro becomes highly sensitive to fiscal and bond narratives. Although the euro's response has been muted compared to past episodes, there is still room for it to catch up with the fiscal story.

EUR/USD may see a 3% risk premium buildup on the euro, which would be in line with previous history, suggesting a move to 1.110 as a possibility in a scenario of further spread widening. EUR/CHF is historically the cleanest way to hedge eurozone fiscal risk, but the franc's idiosyncratic fragilities may get in the way.