When the European Central Bank (ECB) meets next Thursday, it is widely expected to leave interest rates unchanged, partly because rising government bond yields are already pushing up borrowing costs across the eurozone.
ECB President Christine Lagarde has played down hopes of a rescue, saying the solution to France’s debt problems lies at home.
The yield on France’s 10-year government bond traded above 5% on Friday after rising to that level on Wednesday for the first time since 2002. The gap with German 10-year bonds, the eurozone’s safest debt, was above 170 basis points.
Meanwhile, the 30-year yield was at 5.5%, and the gap with German 30-year bonds was even wider at 184 basis points.
On Thursday, the cost of France’s five-year credit default swaps, contracts that insure investors against a government default, also climbed above 100 basis points for the first time since October 2012, when the eurozone was going through its sovereign debt crisis.
Lawmakers remain split over next year’s budget, which includes €43 billion in spending cuts and additional revenue measures that the government has no majority to push through.
Ratings agency Moody’s, which rates France Aa3, its fourth-highest grade, with a negative outlook, delivers its verdict on Friday evening, and a downgrade is widely expected. A one-notch cut to A1 would put France’s rating at the equivalent level to those assigned by S&P and Fitch.
Civil unrest is adding to investors’ concerns.
More protests are expected this weekend, and Paris police prefect Patrice Faure has advised business owners in a letter to hire private security.
French trade unions, unanimously disappointed after meeting Prime Minister Sébastien Lecornu on Wednesday, have called for a large mobilisation on 5 November.
Sophie Binet, head of the CGT, one of France’s biggest unions, urged workers to “generalise the strike”.
Bonds doing the ECB’s job
The case for another rate hike is still there.
The ECB has raised rates twice this year, lifting its deposit rate to 2.5%, and eurozone inflation jumped to 3.8% in September, driven by energy prices.
Yet German yields have climbed so much since September that their effect on growth and inflation roughly matches a 25 basis point hike, Carsten Brzeski, global head of macro at Dutch bank ING, estimated in an investor note on Thursday.
“For France, it’s closer to a 50 basis point hike,” Brzeski wrote, adding that “the bond market has taken over the ECB’s job”.
Brzeski expects the ECB to wait for new staff forecasts in December before deciding on its next hike.
ECB President Christine Lagarde told the European Parliament on 28 September that long-term rates “have risen notably, which will slow growth”.
Could the ECB intervene?
ECB officials have played down the possibility of intervening to lower France’s borrowing costs, but have stopped short of ruling it out.
The central bank bought government bonds during the eurozone debt crisis to stabilise markets and ensure its rate decisions continued to feed through to the economy.
Speaking on the sidelines of the annual meetings of the International Monetary Fund and World Bank in Bangkok last week, Lagarde said that “there are particular circumstances that lead to some countries being more affected, France being a case in point.”
“The primary and first solution lies at home in France. And it has to do with fiscal policies,” the ECB president added.
Banque de France governor Emmanuel Moulin went further last Friday, saying the conditions for ECB intervention were not met at that time because there was no financial fragmentation in the eurozone.
However, both officials spoke before France’s 10-year borrowing costs rose above 5%.
If the ECB decides to intervene in the French bond market, one option could be the Transmission Protection Instrument (TPI), which was created in 2022 and has never been used.
The TPI lets the ECB buy the debt of countries whose borrowing costs climb in ways it judges unjustified by their economic fundamentals and threaten the transmission of monetary policy across the eurozone.
For a country to be eligible, it needs to meet several criteria, including following EU fiscal rules and keeping its debt on a sustainable path.
France is nursing a debt-to-GDP ratio of 119.1%, and the current budget negotiations offer little prospect of a quick reduction in the deficit, which is necessary to put the debt on a sustainable path.
Meanwhile, the government expects its debt-servicing costs to rise by more than €10 billion in 2027 compared with this year.
“The bar for activating the ECB’s bond-buying programme remains high,” Brzeski wrote in a separate investor note last week.
He added that, for France, that would at least mean passing its full budget. Acting too early could be “interpreted as monetary financing of the debt of a country unwilling to follow the rules,” he warned.
The ECB’s other emergency tool, Outright Monetary Transactions (OMT), was created in 2012 at the height of the eurozone debt crisis to allow unlimited purchases of a struggling country’s short-term bonds.
However, it is only available to governments that first sign up to a bailout programme from the eurozone’s rescue fund, the European Stability Mechanism.
Instead, Brzeski expects the ECB to quietly pause the reduction of its bond holdings, reinvesting maturing debt flexibly as it did during the COVID-19 pandemic.
Should turmoil spread to other eurozone bond markets, Brzeski sees TPI as a last resort. If France continued to fall short of EU fiscal rules, “the ECB might even consider purchasing bonds from almost all eurozone countries, except for France,” he said.
For now, Brzeski sees next week’s rate meeting as “uneventful on action but clearly not on words”.