The French-German 10-year spread is the key gauge: MUFG’s scenarios put it at about 170 basis points in its base case and above 200 in a crisis, levels last associated with the euro zone debt crisis. EUR/USD has been tracking the two-year swap spread between the euro and the dollar closely, so any further scaling back of ECB hike expectations is likely to weigh on the currency, while a firm December signal would offer some support. In bonds, heavy redemptions from the ECB’s portfolio in coming months put the pace of quantitative tightening in focus. Any hint of a slowdown could ease pressure on French debt. Energy remains a swing factor: MUFG’s forecasts assume supply risks fade, so persistently high oil and gas prices tied to the Middle East conflict would challenge both its rate path and its call for a gradual euro recovery.
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Earlier:
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MUFG expects the ECB to hold next week as higher bond yields and French fiscal stress tighten conditions for it, but still sees two more hikes, with France the biggest risk to the euro.
Summary:
MUFG says the bond sell-off and French fiscal risks have removed the case for an October ECB rate hike, as officials highlight the drag from tighter financial conditions.
It still expects a 25 basis point hike in December and another in the first quarter of 2027, taking the policy rate to 3.00%, then a cut back to 2.75% by the third quarter of 2027.
Resilient activity and higher gas prices since September justify moving into slightly restrictive territory on a risk-management basis, while underlying inflation remains contained.
MUFG’s base case, given 45% probability, is continued French fiscal drift, with the deficit at 5.6% to 6.0% of GDP, the French-German spread near 170 basis points, and EUR/USD in a 1.08 to 1.14 range.
In a deeper credibility crisis (15%), it sees the spread above 200 basis points and EUR/USD between 1.02 and 1.10, with the ECB’s TPI potentially in focus.
MUFG forecasts EUR/USD at 1.12 by year-end, recovering gradually to 1.18 by the third quarter of 2027.
The European Central Bank is set to keep rates on hold at next week’s policy meeting, but MUFG argues the tightening cycle is not over, even as rising bond yields and French fiscal stress do some of the work for policymakers.
In its October European outlook, MUFG said the bond market sell-off and growing fiscal risks in France have taken an October rate hike off the table. ECB officials have increasingly pointed to the impact of tighter financial conditions on the outlook, and underlying inflation pressures remain contained. Even so, the bank’s strategists argue that resilient economic activity and higher gas prices since September still justify a move into slightly restrictive territory as a risk-management measure. MUFG expects a 25 basis point hike in December and another in the first quarter of 2027, taking the policy rate to 3.00%. It then sees the ECB cutting back to 2.75% by the third quarter of 2027, a path that assumes energy supply risks fade.
France is at the centre of the outlook. MUFG notes that a fragmented parliament has led successive governments to miss fiscal targets repeatedly, leaving the deficit close to 6% of GDP despite several consolidation plans. With public debt around 120% of GDP, the bank says France has little room for further slippage and is highly exposed to weaker growth or a rise in borrowing costs. The IMF’s latest forecasts already show France as the clear outlier among major European economies, with growth seen at just 0.4% this year.
The strain is visible in the bond market. The spread between French and German 10-year yields has widened to levels last seen during the euro zone debt crisis, while France’s annual interest bill has climbed to a record. MUFG suggests that a high and rising share of French debt held by foreign investors may have amplified the sell-off. Contagion has so far been limited, with Italian spreads relatively contained.
The bank sets out four scenarios ahead of France’s presidential election, in which it describes Marine Le Pen as the frontrunner. Its base case, given 45% probability, is continued drift: the government survives by relying on procedural mechanisms, measures are diluted or delayed, and the deficit stays between 5.6% and 6.0% of GDP. In that case, MUFG sees the French-German spread around 170 basis points and EUR/USD in a 1.08 to 1.14 range. It would not force an immediate ECB response, but quantitative tightening could come under review.
A deeper credibility crisis, at 15%, would bring acute political instability, a recession and a deficit well above 6% in 2027. That would push the spread above 200 basis points and drive EUR/USD down to between 1.02 and 1.10, with investors looking to the ECB’s Transmission Protection Instrument as a potential backstop. On the more positive side, limited consolidation (35%) would leave the spread near 110 basis points, while faster consolidation (5%) would narrow it to about 90 basis points and support EUR/USD in a 1.12 to 1.18 range.
For the currency, MUFG says the scaling back of ECB hike expectations has already helped weaken the euro, which has closely tracked short-term rate differentials with the US. The bank expects the dollar to remain stronger for longer. It forecasts EUR/USD at 1.12 at the end of this year before a gradual recovery to 1.14 in the first quarter of 2027, 1.16 in the second and 1.18 in the third.
With policymakers in their quiet period, next week’s statement and press conference will be watched for how much weight the ECB gives to tighter financial conditions and French fiscal risks, and whether it keeps the door open to a December move.
This article was written by Eamonn Sheridan at investinglive.com.
