By Dhara Ranasinghe and Alun John
LONDON, Oct 5 (Reuters) - A sliding euro is the latest alarm bell for policymakers facing a surge in French borrowing costs that has started to spill over into the broader euro area.
The euro hit 17-month lows below $1.12 on Monday and tumbled against sterling, the Swiss franc and Japan's yen.
France is at the heart of the European market concerns.
The French government is seeking to enact an unpopular 2027 budget to lower its deficit and contain its record-high debt
load, a tall order in a deeply divided parliament as political factions position ahead of next year's presidential election.
Investors, unwilling to take chances, are dumping French bonds while buying safe German debt.
With the premium investors demand to hold French over German government bonds now at its highest since the 2010-2012 euro zone debt crisis, currency markets fear contagion.
At stake is feeble economic expansion in a bloc rocked by political uncertainty. Chancellor Friedrich Merz's party last month suffered the worst regional election defeat in postwar Germany. And on Monday, Spanish Prime Minister Pedro Sanchez called a snap election. Italy also holds elections next year.
With inflation already rising on soaring energy costs and higher yields increasing household and corporate borrowing costs, further euro weakening could leave the European Central Bank caught between fighting inflation and calming bond markets.
The French/German 10-year bond yield gap last week saw its biggest weekly jump in decades, while the gap between Italian and German yields hit almost 130 basis points (bps), posting its biggest weekly rise since the COVID-19 crisis.
"The bond sell-off is seeing bigger moves in anything that is perceived in any way, shape, or form as more vulnerable, and that has seen an outbreak of euro selling that's gathered momentum," said Societe Generale's chief FX strategist Kit Juckes.
"The factors that held euro/dollar above key levels through the summer... I think that's gone," he said, pointing to earlier assumptions of a short-lived energy shock and a US push to weaken the dollar.
NEW DIMENSION TO EURO WEAKNESS
While the euro is comfortably above 20-year lows hit in 2022 when Russia's invasion of Ukraine sparked an energy crisis, the bond market moves add a new dimension to euro weakness.
Every further 10 bps widening in the French spread against Germany would be associated with a 0.4% fall in euro/dollar, BofA FX strategists estimate.
"The typical response is closer to zero most of the time, but (the spread impact) can rise significantly in times of acute stress," Goldman Sachs analysts said in a note.
"Spreads do not matter for the currency until they are the only thing that matters," they said, adding that the impact on the euro rises when a risk event pushes German yields down, but those elsewhere in the bloc higher.
This was the case last week when Germany's Bund yield fell almost 17 bps, its biggest weekly drop since 2024.
"Euro/dollar is usually influenced more from the dollar side, but this time there is an impact from Europe too," said Amundi Asset Management's head of global FX Andreas König.
"You have to go back a bit in time to when European headlines last made the euro move," he said.
König did not see a turnaround in the medium term and was sticking with a dollar overweight position given the US growth and rate outlook.
CFTC positioning data show traders positioned for a fall in the euro, a view also reflected in currency options.
Three-month euro risk reversals, which reflect the difference between the cost of an option to buy the euro against the cost of one to sell it, fell on Friday to their most bearish since 2024.
Analysts said the euro could test $1.10, while SocGen's Juckes also highlighted euro vulnerability against the likes of the yen and Swiss franc. The euro fell almost 4% against the yen in September.
A falling currency alongside bond market stress means talk has turned to how policymakers could stabilise markets, especially if 2027's French election causes more strain.
The ECB's Transmission Protection Instrument allows it to buy an unlimited number of bonds from a country experiencing an "unwarranted, disorderly" tightening of financing conditions.
For now, growth, though weak, has strengthened.
Euro zone business activity expanded at its fastest pace in nearly 3-1/2 years in September, S&P Global data showed. The degree to which banks, the main financiers of companies in the region, can keep lending to their economies is also in focus.
"If the fiscal contagion risk in Europe is not contained, I can see euro/dollar trading lower, despite the fact that it was already slightly undervalued," said Stephen Jen, CEO and co-CIO of Eurizon SLJ Asset Management.
(Reporting by Dhara Ranasinghe and Alun John; editing by Alexander Smith)
