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Widening Eurozone spreads, led by a surge in France’s bond yields, have become a dominant concern for the markets. French OAT-Bund spreads widened past 130-140bp this week, highest since the euro-area debt crisis, and showing early signs of broadening out to the other members, for instance leading to a wider Italy-Bund spread. By contrast, German bonds rallied on risk-haven appeal. Wider spreads despite a repricing of ECB expectations point to deeper structural concerns underpinning the bond sell-off.
Fiscal and political troubles in France have contributed to the wide risk premium, with fiscal plans outlined by the government on Thursday to sharply narrow the budget deficit from an estimated 5.4% of GDP in 2026 to 5.0% of GDP (vs preferred 3%) failing to stoke confidence. This consolidation not only assumes lower spend on controversial areas including welfare, state-sector wages, pensions, but also imposes a higher tax burden. The math also rests on an optimistic growth assumption of 1.0% in 2027, vs downside risks to the projected 0.7% yoy this year. Delay in budget rationalisation efforts could public debt to GDP ratio past 120% of GDP.
Most key macroeconomic indicators have weakened since Fitch Ratings's September 2025 downgrade, raising the likelihood of renewed pressure on the sovereign rating outlook. Concurrently, the rising popularity of hard-left and far-right parties in recent state polls have raised the prospect of further fractures in the parliamentary process, ahead of presidential elections in 2027. The far-right party's stronger polling has increased the probability of a second-round run-off, raising the risk of policymaking gridlock given its unwillingness to work with the incumbent administration.
Markets have turned attention to the possibility of potential ECB intervention to cap the surge in bond yields. The ECB has so far shown little appetite to backstop French debt, with ECB policymaker Joachim Nagel pushing back against expectations of intervention and reaffirming that bond-purchase tools are not designed to target specific sovereign spreads. Moral hazard risks of an early action are high. The unutilised Transmission Protection Instrument (TPI) mechanism was created in July 2022 for the ECB to buy bonds to contain episodes of market panic, provided member countries had followed key EU budget rules and the sell-off was due to an outright marker disorder.
Investors are watchful if the widening eurozone spreads, not only broadens in scope to other highly indebted countries within the Eurozone but also impacts the euro. Before triggering the TPI, risks of a contagion might see the ECB tone down the hawkish guidance, cease quantitative tightening measures, undertake verbal intervention, and channel maturing papers. Risks of further increase in inflation in 4Q, will put rate decisions in a tough bind. We also note that the current global environment differs from the past, as the US also faces significant fiscal-inflation concerns and the run-up in the French/ member country bonds has also been partly triggered by a surge in global energy prices. Hence, a material shift in the risk environment on either count could help stall a further escalation in the EZ bond sell-off.
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