The Eurozone is descending into chaos: following Germany in September, tensions are flaring up in France and Spain in October. The inability of European governments to curb mounting deficits and national debt is becoming a powerful catalyst for capital flight from the region and a sharp decline in EURUSD quotes. The situation in France looks particularly alarming: Paris is spending more on servicing its obligations than previously troubled Greece and Italy. The budget gap in France already exceeds that of the US, and national debt is rapidly approaching the psychological threshold of 120% of GDP. Meanwhile, neither left-wing nor right-wing political forces show any willingness to enforce strict fiscal discipline.
Equity and debt markets are reacting sharply: the cost of insurance (CDS) against French sovereign default has more than doubled over the past week. A similar dynamic is observed in the hedging of risks for Italy and other peripheral EU countries. Investors are alarmed by Paris’s plans to issue a record €340 billion in bonds to keep the budget deficit capped at 5% of GDP. With the current yield on 10-year bonds above 5%, the Ministry of Finance estimates that debt servicing costs will surge by 59% by 2030.
Against this backdrop of risks, capital is naturally seeking refuge in more stable jurisdictions, primarily the US dollar. The US yield curve is moving out of the inversion zone, which the market interprets as a signal that the economy can avoid a recession.
Following the speech by New York Fed President John Williams, market expectations for a federal funds rate hike in October have adjusted downward from 73% to 24%. This is restraining the outpaced growth of 2-year Treasury yields relative to 10-year yields. Nevertheless, the probability of monetary tightening this month has increased from 18%. This was driven by a surge in the ISM services sector price index to its highest level since 2022, alongside a return to employment growth after two months of decline.
Investors are actively buying the US dollar, attracted by the high yields of Treasuries, the fundamental resilience of the US economy, and its status as a safe-haven asset during periods of heightened geopolitical tension. The derivatives market is pricing in a more aggressive monetary tightening cycle by the Fed compared to other global central banks. In contrast, the ECB is constrained: it is held back by political and fiscal threats, as well as fears of triggering an economic downturn through further rate hikes.
The euro continues to face severe pressure due to the risk of the “French disease” spreading to other regional debt markets, as well as deteriorating terms of trade (the Eurozone remains a net importer of energy resources). There are no rays of hope on the horizon yet; on the contrary, snap elections in Spain are only fueling the panic, leaving the major currency pair EURUSD with little to no chance of a recovery in the near term.
