Citi warns French fiscal risks could halt ECB hikes

Citi analysts say France's worsening public finances could lead the European Central Bank to stop raising interest rates after a December hike, or sooner if financial stress spreads to other heavily indebted euro zone countries. They also warn that the euro is exposed to further losses.finance.biggo+1

The note runs against market pricing, which still assumes the ECB will keep tightening. According to Citi, a December increase is almost fully priced in, along with nearly two more hikes in 2027. The bank argues that the ECB's focus is shifting from inflation to financial conditions, which raises the question of how much more tightening it can deliver.investing

A reversal in the bond market

Citigroup ↗ 1.22% rates strategists point to a change in how ECB rate expectations relate to the gap between French and German bond yields. Markets used to treat the two as moving together. Now investors worry that further hikes would tighten financial conditions and push up risk premiums on euro zone assets. Citi says ECB pricing has room to fall 50 to 75 basis points relative to the U.S. Federal Reserve. Its top trade is receiving ECB rates against Fed rates, a bet that ECB expectations will come down further than Fed expectations.finance.biggo+1

The bank's FX strategists said EUR/USD could fall below 1.10 if the euro drops beneath the fair value implied by two-year rate differentials. Their model suggests that narrowing the euro-U.S. two-year spread by 50 to 75 basis points could push the pair toward 1.1075 to 1.1000, even if the euro stays at fair value. Citi said the trade would still hold up if tensions involving Iran ease and lower commodity prices support French assets and the euro.investing

France under pressure

France's 10-year bond yield has risen nearly 80 basis points since the start of September and reached its highest level since July 2002, just short of 5%, Reuters reported. Euro zone finance ministers and the ECB were set to urge Paris on Oct. 8 to pass a 2027 budget to calm markets. Officials said they saw no sign yet of contagion to other euro zone countries.reuters

Prime Minister Sébastien Lecornu's minority government aims to cut the deficit from an expected 5.4% of GDP this year to 5.0% in 2027. Investors doubt the plan can pass a fragmented parliament before presidential and legislative elections in April and May 2027. The National Assembly is due to hold its first vote, on the revenue section of the budget, on Oct. 20.mufgresearch+1

The ECB's path

The ECB raised its deposit rate by 25 basis points to 2.50% in September. Economists polled by Reuters expect it to hold rates at its Oct. 29 meeting and hike again in December. Morningstar noted that policymakers have suggested rising long-term borrowing costs could reduce the need for further increases.reuters+3

Citi said two things will test its view: how France's fiscal risks develop, and whether the ECB's December meeting signals slower tightening.finance.biggo