A french fright

French sovereign bonds and equities took a hit on Wednesday, with investor worries deepening over a contentious draft budget that could topple Prime Minister Michel Barnier’s government. As the discord escalated, the spread of French debt widened to levels not seen since 2012. Despite the turmoil, the euro has remained relatively resilient, propped on month-end demand, increased expectation of a December Fed rate cut and easing US yields.

On the macroeconomic scene, the U.S. core Personal Consumption Expenditures (PCE) deflator for October met market forecasts, climbing by 0.3% month-over-month and a 2.8% increase from a year earlier. This data aligns perfectly with Bloomberg's consensus expectations and confirms predictions by market analysts. Complementing this, the number of weekly applications for U.S. unemployment benefits dropped more than anticipated, underscoring the labour market's robustness.

Collectively and likely politically, this data drop bolstered market expectation that the Federal Reserve might opt for a 25-basis-point cut in its December meeting. Consequently, the dollar showed slight weakness. Even though we read core as very sticky, the market's obsession with inflation has dimmed for now.

However, the balance of risk remains contingent on updated U.S. inflation and employment data for November, which will more definitively shift the odds for the Fed’s rate cut decision to either above a 75% likelihood or below a 50% probability.

If the political backdrop in France deteriorates further, there's a real risk that French government bonds could plummet into the plunge tank and drag the euro down with them.

Line chart of 10-year spread relative to Germany, percentage points showing French bond spreads hit highest level since Eurozone crisis
Marine Le Pen, the leader of the far-right Rassemblement National, has become a pivotal figure in the unfolding political drama in France. As her party holds significant sway in the lower house, their support is crucial for any censure motion to succeed. After a meeting with Prime Minister Michel Barnier on Monday, Le Pen expressed dissatisfaction, stating that Barnier was unresponsive to her demands to shield the French populace from tax increases. She reiterated her threat to topple the government if her demands are unmet.