Francesco Pesole at ING notes that widening French OAT-Bund and OAT-BTP spreads have yet to materially weigh on the euro, but warns that sensitivity to French sovereign risk could return rapidly if spreads approach 200bp. He maintains a broadly bearish EUR outlook, highlighting EUR/CHF as a key sovereign-risk proxy and EUR/USD’s potential to re-test 1.1120 if bond market turmoil persists.

French spreads threaten Euro stability

“The OAT-Bund 10yr spread closed at 174bp after touching 178bp yesterday. That wasn’t the only EU sovereign spread widening yesterday; bunds outperformed (+9bp) on haven demand, and energy prices played a role too.”

“But OATs saw the only increase in 10yr yields in Europe (+6bp), and the OAT-BTP spread has reached a grim 50bp milestone. The budget/political situation is not visibly deteriorating, so the move is probably a function of OAT’s simply having a higher beta to global factors and perhaps some concerns about another weekend of social unrest in France.”

“The euro’s sensitivity to France has clearly diminished, with the common currency not materially underperforming G10 peers yesterday. That link may, however, re-establish very rapidly should a new pain level – perhaps 200bp – be breached. We aren’t expecting that much further widening for now, but the risks are clearly there, and the euro remains rather unattractive across the board.”

“EUR/CHF remains the cleanest way to play European sovereign risk at the moment, while EUR/USD should be quick to re-test the 1.1120 14 October low should bond turmoil persist.”