The euro sank to a 17-month low on Monday as a sell-off in French government bonds spread fears of contagion across the euro area. France's widening borrowing costs are now bleeding into currency markets, with traders positioning for further euro declines.
The euro fell below $1.12 on Monday, its weakest level in 17 months, and also dropped against sterling, the Swiss franc and the yen. France sits at the center of the turmoil.
France's budget fight unsettles bond markets
France's government is pushing an unpopular 2027 budget meant to lower its deficit and contain record debt, a tough task in a divided parliament as parties jockey ahead of next year's presidential election. Investors are dumping French bonds while buying German debt instead.
The premium investors demand to hold French bonds over German bonds is now at its highest since the 2010-2012 euro zone debt crisis. The French-German 10-year yield gap posted its biggest weekly jump in decades last week, while the Italian-German gap hit almost 130 basis points, its biggest weekly rise since the COVID-19 crisis.
Political strain is not confined to France. Chancellor Friedrich Merz's party suffered its worst regional election defeat in postwar Germany last month, Spanish Prime Minister Pedro Sanchez called a snap election on Monday, and Italy also holds elections next year.
Spreads now drive the currency
Every further 10 bps of widening in the French spread against Germany is tied to a 0.4% fall in euro/dollar, BofA FX strategists estimate. Goldman Sachs analysts put it bluntly: "Spreads do not matter for the currency until they are the only thing that matters," they said in a note.
Germany's Bund yield, meanwhile, fell almost 17 bps last week, its biggest weekly drop since 2024. CFTC positioning data show traders positioned for a fall in the euro, a view also reflected in options markets.
There, three-month euro risk reversals turned their most bearish since 2024 on Friday. Analysts said the euro could test $1.10, and the currency already fell almost 4% against the yen in September.
The European Central Bank's Transmission Protection Instrument allows it to buy an unlimited amount of bonds from a country facing an "unwarranted, disorderly" tightening of financing conditions. For now, growth has held up: euro zone business activity expanded at its fastest pace in nearly 3-1/2 years in September, S&P Global data showed.
Still, with inflation already rising on higher energy costs, further euro weakness could leave the ECB caught between containing prices and calming bond markets. Stephen Jen, CEO and co-CIO of Eurizon SLJ Asset Management, said that if the fiscal contagion risk in Europe is not contained, he can see euro/dollar trading lower, despite the currency already being slightly undervalued.
Source: Investing.com
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