The crisis in France could affect other countries. Which bonds are investors watching?

There is still no end in sight to the crisis in France, and investors are already assessing the risk of it spreading to other eurozone countries. Their focus is not only on France, but also on Italy, Spain, and Greece. How likely is a new crisis in Europe?

The yield on 10-year French government bonds soared to 4.97%—a high not seen in nearly a quarter-century. Macquarie Bank notes that the budget deficit is expected to reach 5.4% of GDP by the end of 2026, while public debt is projected to reach 119.3% of GDP. The country has been experiencing two weeks of mass protests by government employees, as well as high school students dissatisfied with overcrowded classrooms, a shortage of teachers, and the poor condition of schools.

Even far-right leader Marine Le Pen has promised to drastically cut government spending if she comes to power in 2027, and has called on the European Central Bank to “intervene” in the government debt market and “ease the burden of interest rates” to give eurozone countries more opportunities to invest in defense, technology, and the green transition.

In fact, none of the politicians are willing to admit that the situation with public finances has spiraled out of control, writes Bloomberg columnist Lionel Laurent.

The far left wants to write off the national debt and tax the rich, but he believes that’s pure fantasy. On the other hand, there’s Le Pen, who has proposed enshrining a cap on government spending in the constitution, but this is “nothing more than a fig leaf meant to cover up all her own promises to hand out benefits.”

"Voices from the political center are 'completely silent,'" Laurent notes: “Meanwhile, schools are burning in France—and this is the most striking manifestation of a policy that for decades has ensured a comfortable life for retirees while simultaneously failing to invest in the future.”

Which of them might be targeted?

Elections will be held in France, Italy, and Spain in the foreseeable future, according to a Commerzbank analyst note released in October.

The presidential election in France and the parliamentary election in Italy are scheduled to take place in the second quarter of 2027. Meanwhile, on October 5, Spain’s prime minister announced early elections due to the housing and immigration crises, which added to market uncertainty.

Many analysts have pointed to the widening spread between French and German government bond yields—a market indicator of declining confidence in France’s financial stability. However, according to a Commerzbank note, a similar trend is also occurring with comparable spreads on Italian and Spanish government bonds.

“Although this trend is much less pronounced [than with French bonds], the market appears to be pricing in the likelihood of a more serious crisis,” the bank’s analysts note. This is especially true given the problems in global bond markets, where, for example, the yield on 10-year U.S. Treasury bonds has risen to its highest level since 2002.

The spread on French bonds (relative to German bonds, which are considered the benchmark) jumped to 1.4 percentage points this week, whereas in early to mid-September it was less than 0.9 percentage points. For Italian and Greek bonds, the spread exceeded 1.1 percentage points as early as the beginning of October, and for Spanish bonds, it exceeded 0.6 percentage points, according to analysts at Macquarie Bank.

This means that investors have begun to place a higher value on the risks of increasing instability in these countries.

The euro fell to a 17-month low of $1.116. On Friday, the European currency is trading at around $1.12.

"The massive sell-off of French government bonds has 'heightened concerns about the destabilization of the financial situation in the eurozone,'" said Lee Hardman, senior currency analyst at MUFG.

Added to this were concerns about “risks of fragmentation in the eurozone,” similar to those during the debt crisis in the early 2010s, which could complicate the ECB’s conduct of monetary policy. Taken together, these factors triggered a decline in the euro, Hardman noted (as quoted by the Financial Times).

"The political situation in Europe is indeed starting to deteriorate," added Erik Robertsson, chief strategist at Standard Chartered.

As for France, which has become the epicenter of the risk, “it has neither the desire nor the ability to get its finances in order,” he believes.

The current situation in France is serious, but not everyone in the market agrees that it resembles the eurozone debt crisis of the first half of the 2010s.

"We are cautious in our assessment of the euro's outlook, but comparisons with 2012 do not hold up to scrutiny," says Jeffrey Yu, senior strategist at BNY.

The spread on Greek bonds—which were at the epicenter of the crisis at the time—reached a peak of 30 percentage points, according to Macquarie analysts. For Italian and Spanish bonds, which were also affected at the time, the spread exceeded 5 percentage points and 6 percentage points, respectively. And even for France, whose fiscal position was much better then than it is today, the spread approached 2 percentage points.

“The big question is whether this marks the beginning of a new sovereign debt crisis in the eurozone or an overreaction by the markets. I’m leaning toward the latter,” the FT quotes Jim Reid, global head of macro research at Deutsche Bank, as saying.

The ECB has the tools to counteract unwarranted and chaotic market movements if they begin to threaten the effective implementation of monetary policy. ECB President Christine Lagarde made this statement to eurozone finance ministers in response to a question about rising yields, participants in the closed-door meeting told Bloomberg. However, it remains unclear which countries’ markets the central bank will support.

Regulators have also begun conducting additional stress tests on banks to assess the risks associated with their government bond portfolios, François-Louis Michot, chairman of the European Banking Authority, told the agency.

Managers at several large investment funds told the FT that they have begun buying up bonds caught up in the sell-off. For now, their focus is not on French government bonds that have fallen sharply in price, but rather on securities that have suffered collateral damage. Alex Everett, a fund manager at Aberdeen Investments, is betting on a rebound in Italian bonds.

"Despite recent volatility, the European government bond market today enjoys significantly stronger institutional support and the confidence of its participants," he said.

Jason Borbor-Shin, a portfolio manager at Ninety One, sees no point in increasing the allocation to French government bonds ahead of the 2027 election, but is increasing his exposure to other assets that have been hit by the sell-off and are fundamentally “very weakly correlated with French sovereign risk.”

Some fund managers are investing in French companies, particularly those with significant international operations. Currently, 38% of investment-grade corporate bonds (with a face value of €215 billion) are trading at yields lower than those of government debt. At the beginning of the year, such bonds totaled €12 billion, according to Bloomberg.

In other words, the market has come to view companies such as L’Oréal and TotalEnergies as less risky borrowers than the French government.

Although government bonds are traditionally considered the safest, “the corporate credit market in France is becoming increasingly decoupled from the government bond market,” says Eliza Belghassem, senior credit strategist at Generali Investments.

For Edward Farley, director of European investment-grade corporate bonds at PGIM, the key factor is where companies make their money. For example, the only significant factor linking L’Oréal and LVMH to France is the fact that they are registered there, Farley told Bloomberg.

This article was AI-translated and verified by a human editor