Citi: French fiscal risks may cause ECB to pause rate hikes after December, euro likely to drop below 1.10

Citi, in its latest report, presented an outlook different from mainstream market expectations: France’s public fiscal risk may constrain the European Central Bank from further tightening monetary policy. If fiscal pressures continue to intensify, the ECB may pause after the December rate hike; if financial pressures spread early to other eurozone countries, the pause might come even sooner. As a result, the euro against the US dollar may also fall below 1.10.

Citi rate strategists pointed out that the relationship between the ECB rate expectations and the yield spread between French and German government bonds has already reversed, reflecting a changing market attitude towards further monetary tightening. As France’s fiscal risk rises, investors may grow increasingly concerned that further rate hikes will tighten financial conditions even more.

The currency market may be the first to reflect this change. Citi FX strategists believe that if the euro breaks below fair value implied by the two-year yield differential, the EUR/USD pair could test the 1.10 level. Citi’s two-year valuation model shows that if the yield differential between the eurozone and the US narrows by 50 to 75 basis points, even without an extra deviation from fair value, the exchange rate may drop to the 1.1075 to 1.1000 range.

Citi has listed going long on Fed rates and short on ECB rates as its preferred trading strategy, i.e., betting that ECB rate expectations will be revised lower relative to those of the Fed. Although the market has almost fully priced in an ECB rate hike in December and factored in nearly two more hikes before 2027, Citi believes French fiscal risk could prompt investors to reassess the ECB’s policy path and leave room for an adjustment of 50 to 75 basis points in related trades.

French fiscal risk begins to impact ECB policy expectations

Citi’s core view is that French fiscal risk may influence the ECB’s policy choices through its effect on financial conditions. As the risk premium on French bonds rises, overall financing conditions in the eurozone may tighten. If the pressure further spills over into other highly indebted member countries, the cost of continued ECB rate hikes would also increase.

This means that even if inflation pressures persist, the ECB may not continue raising rates in line with current market expectations. Financial market volatility triggered by fiscal risk could become a key variable influencing its policy path.

Narrowing spreads may push the euro towards 1.10

Citi expects there is still room for another 50 to 75 basis points of downward adjustment in ECB rate expectations relative to the Fed. According to its two-year valuation model, a narrowing of the two-year yield differential between the eurozone and the US by 50 to 75 basis points could see EUR/USD fall to the 1.1075 to 1.1000 range, even without additional currency overshooting.

The key point here is that the market is still pricing in continued ECB rate hikes. If French fiscal risk leads investors to revise down expectations for the ECB’s terminal rates, while the Fed’s policy outlook remains unchanged, the narrowing transatlantic rate spread may further weigh on the euro exchange rate.

Citi bets on relatively lower ECB rate expectations

Citi’s preferred trading strategy is to go long on Fed rates and short on ECB rates, betting that the rate differential will further shift in favor of the Fed.

Citi believes this strategy remains attractive even if tensions in Iran ease. Easing geopolitical tensions and falling commodity prices may support the French stock market, government bonds, and the euro, thus making direct shorts of these assets less appealing. However, the impact of French fiscal risk on ECB policy expectations may not dissipate just because energy prices fall back.

Looking ahead, how France’s fiscal risks evolve, and whether the ECB’s December meeting signals a slower tightening pace, will be important factors to watch in testing Citi’s judgment.