Why France’s budget problems have driven its bond risk premium to 2012 highs

On September 18, the premium that France pays to borrow on the bond markets compared to Germany surged to over a full percentage point for the first time since the euro zone debt crisis, signaling increasing investor concerns over France's financial situation ahead of the upcoming presidential election. This rise in the premium, now over 100 basis points, is a result of France's 10-year borrowing costs outpacing those of any other developed economy amid a global bond selloff driven by rising energy prices.

Investors are worried about the long-term financial health of France as it grapples with cutting its high budget deficit before the presidential election that could exacerbate the situation.

The French government now has to pay a 104-basis-point premium over Germany's 10-year bonds for the first time since 2012, reflecting the widening spread between the two yields, which has doubled since the snap election of 2024. The election resulted in a fragmented parliament, making it challenging to reduce France's budget deficit, one of the highest in the euro zone.

The government aims to decrease the deficit from 5.4% of output this year to 5% in the following year through €54 billion worth of tough spending cuts. However, opposition parties are likely to challenge these measures in the coming months, potentially leading to a government collapse.

France's budget deficit is projected to miss the original 5% target for this year due to lower-than-anticipated growth. Rising energy costs, stemming from the Middle East conflict, which have driven investors to anticipate further European Central Bank rate hikes, may further dampen growth. Additionally, there is concern that next year's presidential election could hinder the government's efforts to lower the deficit as Marine Le Pen and Jean-Luc Melenchon are the frontrunners.

Melenchon's proposal to cancel the French central bank's debt holdings has further unsettled investors, while Le Pen, who leads the polls, has advocated for lowering the retirement age, which could strain the nation's finances.

The bond spread for Italy has also increased, but not as significantly as France's, with a 40-basis-point rise since June. The widening gap between France and Italy's bond spreads highlights the growing concerns over France's financial stability. France's bond market, historically regarded as relatively safe, is now losing its status, with the last time France paid a three-digit premium over Germany being during the height of the euro zone debt crisis in 2012.

David Zahn, head of European fixed income at Franklin Templeton, expressed concern over France's situation, stating that the country's bond market is losing its safety status, and investors are increasingly reluctant to favor French bonds in their portfolios.