Why is the euro lagging as French risks ripple through the Eurozone?

• EUR/JPY slips towards 177.45 as France’s political risks spill over into other Euro nations.
• An unchanged policy rate stance is expected from the ECB at its October policy review.
• The BoJ’s Governor Ueda reaffirms that monetary tightening will continue along a gradual path.

Selling pressure leaves the Euro (EUR) trailing its major currency peers in Wednesday’s European session, with the currency down 0.13% against the Japanese Yen (JPY) at around 177.45.

According to market experts, the effects of France’s political crisis are already spilling over into the wider Eurozone, keeping the single currency under selling pressure.

How is France’s turmoil spreading to bonds and the Euro?

European markets have felt the impact of the latest political upheaval in France, according to Deutsche Bank analysts, who observe that “those market concerns around French debt cascaded across other countries and asset classes too.” In sovereign bonds, they note that “the Italian 10yr spread over bunds was also up +4.7bps on the day to 111bps, whilst Spain’s was up +1.2bps to 62bps.” The fallout extended to equities: “the STOXX Banks index (-2.07%)” fell to a four-month low, alongside “even bigger declines for the French banks, including Société Générale (-3.41%), Crédit Agricole (-2.64%) and BNP Paribas (-2.48%).” Turning to currencies, Deutsche Bank says “all that caused fresh pressure for the Euro itself, which weakened -0.23% against the US Dollar to close at $1.1213.”

The speed at which financing conditions have tightened is highlighted by Rabobank’s RaboResearch team. It describes the fixed-income response as “an ugly bond reaction to the ugly protests and looting in France (and Belgium and Italy, following earlier peaceful protests in Spain and Portugal) with 10-year French yields +13bps, Italian +8bps, and German +3bps.” The team adds that “even if we only focus on fiscal metrics, French 10-year borrowing costs are now half a rate hike higher than Friday,” illustrating the rapid rise in funding costs.

For policymakers, Rabobank describes the choice ahead as “the hypothetical whispered realpolitik binary”, namely “between the ECB bailing France out if needed, at a cost to the Euro and the fury of Germany, and not doing so at a cost to EU economic, political, and market stability.” It also asks: “Could the ECB bail everybody else out from French contagion and leave Paris to sort out its mess?” In this setting, the bank’s conclusion is that “whatever happens now, more volatility seems far more likely than a ‘reversion to mean’.”

As for monetary policy, an interest rate hold at the European Central Bank’s (ECB) meeting later this month remains the expectation among market experts.

Will the ECB hold rates as Danske Bank maintains its 2.50% deposit rate call?

An unchanged ECB rate decision remains the forecast of analysts in Danske Bank’s Danske Research Team, who say they “published a new ECB call yesterday”. They continue to expect the central bank to “keep policy rates unchanged on Thursday 29 October, with the deposit rate at 2.50%, in line with consensus and market pricing.” Their assessment is that the existing policy settings remain suitable, making a continuation of the current rate structure likely at the next meeting.

Elsewhere, the Japanese Yen advances against its currency peers other than the Australian Dollar (AUD), with Bank of Japan (BoJ) Governor Kazuo Ueda again emphasising a gradual normalisation of policy.

Does Japan’s stronger inflation cycle support Ueda’s cautious hawkish tilt?

A mildly hawkish message emerges from Ueda’s focus on “underlying inflation near 2%” and a positive wages–prices cycle, although FXS Speechtracker rates the speech at 7/10, just below the BoJ Governor’s historical baseline of 7.4/10. Alongside a tight labour market, he draws attention to inflation driven by both demand and supply, and to the likelihood that long-term rates would rise steadily if the short-term policy rate were increased. The remarks suggest greater comfort with gradual policy normalisation, while financial conditions remain accommodative.

Caution over market intervention nevertheless remains evident: Ueda reiterates that the fundamental approach to tapering bond purchases is unchanged and declines to announce emergency JGB measures in advance. His emphasis on appropriately calibrated policy to anchor core inflation near 2% and stabilise the JGB market supports the view that expectations of a slow but sustained move away from ultra-easy policy could lift the Yen. The BoJ, however, remains guided by incoming data and alert to market instability.