Markets relieved, but France’s fiscal fire still burns

French financial markets are showing signs of stabilization following a political crisis, with the 10-year French-German bond yield spread narrowing to approximately 77 basis points as investors anticipate Prime Minister Lecornu's survival of no-confidence votes and a suspension of pension reforms. While this political stability has prompted some investors to close short positions on French bonds, the proposed suspension of pension reforms, estimated to cost €400 million in 2026 and €1.8 billion in 2027, raises concerns about public finances and potential ratings downgrades, with Goldman Sachs projecting a 0.5% of GDP deficit increase by 2035. French blue-chip stocks saw a 2% rise, largely driven by luxury giant LVMH's results rather than politics, and the banking sector, highly sensitive to political developments, also rebounded, with the euro expected to benefit from the improved stability.

Analysis

French financial markets are showing signs of stabilization following political developments, specifically Prime Minister Lecornu's proposed suspension of pension reform to avert no-confidence votes. The 10-year French-German bond yield spread has narrowed to approximately 77 basis points from nearly 90 bps last week, with Citi anticipating a further tightening towards 75 bps. This narrowing reflects improved investor sentiment regarding political stability, leading some, like RBC BlueBay, to close short positions on French bonds.

Despite short-term political stability, the suspension of pension reforms introduces significant fiscal challenges. Lecornu estimates costs of €400 million in 2026 and €1.8 billion in 2027, which, without offsetting measures, could prevent France's debt-to-GDP ratio from stabilizing. Goldman Sachs projects a permanent suspension would add 0.5% of GDP to the deficit by 2035, pushing debt-to-GDP closer to 130% from the current 113%, maintaining vulnerability to further ratings downgrades ahead of Moody's October 24 review.

French equities show mixed signals; the CAC 40 blue-chip index rose 2%, primarily driven by LVMH's 12% surge post-results, rather than political factors. French mid-caps continue to underperform, suggesting domestic risks persist. Conversely, the banking sector, highly sensitive to bond spreads, saw major players like Societe Generale, BNP Paribas, and Credit Agricole jump over 2%, indicating a positive reaction to reduced political uncertainty and potentially lower wholesale funding costs.

The euro, which had been dented by the political turmoil, is now expected to benefit from this renewed stability. ING suggests the euro looks less "fragile" with the bond spread below 80 bps, anticipating a potential rise in EUR/USD towards $1.160 if Lecornu survives the no-confidence vote, from its current $1.166.

Key Decisions for Investors

• Monitor French sovereign bond yields and the spread against German bunds for sustained political stability and fiscal health indicators.
• Evaluate exposure to French domestic-focused equities, particularly mid-caps, given ongoing fiscal challenges and potential underperformance compared to internationally diversified blue-chips.
• Consider the banking sector as a potential buying opportunity if political stability persists, as reduced bond spread sensitivity could improve profitability.
• Watch for Moody's rating review on October 24, as a downgrade could reintroduce volatility despite current market pricing.
• Assess EUR/USD positioning, as political stability could provide further support for the euro, potentially pushing it higher.