France’s bond market recently sent a strong message to policymakers. The spread between French and German 10-year government bonds surged above 150 basis points last week, reaching its widest level since the euro-area debt crisis. French borrowing costs approached 5%, while concerns over the country’s deficit, debt trajectory and political fragmentation intensified ahead of the 2027 presidential election.

The market reaction is important because it can create a feedback loop. Higher bond yields increase the government’s interest bill, which worsens the fiscal outlook, requiring even more borrowing and potentially pushing investors to demand an even larger risk premium. But there is also a good side as the bond market can force policymakers to change cours.

Chart: OAT-Bund spread 

Governments ultimately need investors to finance their deficits. As long as investors are comfortable buying government debt, policymakers have considerable room to pursue their preferred fiscal policies. But that changes when borrowing costs rise sharply.

If investors are willing to finance France at 3%, a large deficit may be politically manageable. If the market suddenly demands 5%, the cost of servicing that debt becomes much more significant. France’s interest bill is already projected to rise sharply, reaching around €91 billion in 2027 under the government’s current budget assumptions.

At that point, bond market pricing starts feeding directly back into fiscal policy. Fiscal concerns lead to a rise in bond yields and interest costs, and eventually to a deterioration in fiscal outlook and political pressure to consolidate. The market pricing itself can become one of the forces determining future government policy.

The Liz Truss example

The clearest example is the United Kingdom in 2022. The government of Liz Truss announced a large package of tax cuts without corresponding spending reductions. Investors immediately questioned the credibility of the fiscal plan. UK government bond yields surged dramatically, with the 30-year gilt yield rising around 120 basis points between September 22 and September 27 alone, far more than comparable moves in US and German bonds.

The selloff eventually became a financial stability problem because leveraged liability-driven investment funds were struggling with the rapid repricing of gilts. The Bank of England intervened to restore market functioning. The political response followed soon after.

The government progressively abandoned the original fiscal programme, with most of the remaining tax cuts eventually scrapped. The combination of fiscal U-turns and the stabilisation of the gilt market reversed much of the extreme move in yields. Markets can place limits on fiscal policy that governments discover only after testing them.

France is different, but the mechanism is similar

France’s episode is different but the final result might be similar. France’s problem has accumulated over time. Public debt has reached roughly 119% of GDP, while the government expects a deficit of 5.4% of GDP in 2026. Its 2027 budget proposes €43 billion of new measures, taking the total fiscal effort affecting next year’s accounts to around €54 billion, with a target of reducing the deficit to 5% of GDP.

Even that effort would not stabilise the debt ratio. The government’s own projections see public debt rising to around 121.7% of GDP in 2027. This is where the bond market becomes important. The French government needs to convince investors that the debt trajectory can eventually be stabilised, while simultaneously convincing parliament that the required fiscal consolidation is politically acceptable. Those two objectives are difficult to reconcile.

The recent surge in OAT yields therefore increases the pressure on politicians to find a compromise. The government has already emphasised the need for significant savings, while opposition parties are being forced to consider the market consequences of preventing the budget from passing.

And there are signs that the bond-market crisis is affecting the political debate more broadly. Marine Le Pen is now preparing a plan centred on €25 billion of annual spending reductions, explicitly seeking to demonstrate fiscal credibility as French borrowing costs surge. That is an important development because it shows how market pricing can begin to change the political incentives of the actors who will ultimately determine fiscal policy.

The bond market doesn’t need a full U-turn

Markets do not necessarily need France to announce a dramatic fiscal reversal like the UK did in 2022. They may simply need evidence that policymakers have understood the constraint and are taking credible measures to fix the problem. The market might just need a compromise on the 2027 budget, spending reductions and political agreement that makes the budget process more predictable. 

The market could then conclude that the probability of a much worse fiscal outcome has fallen and that alone could cause the risk premium to decline, leading to a tightening in OAT-Bund spread and improving risk sentiment. 

Something similar happened with Trump’s Liberation Day in April 2025. The sharp increase in Treasury yields forced Trump to pause and ease his aggressive reciprocal tariffs. He did confirm later that the he didn’t like the reaction in the bond market. The markets eventually rebounded strongly just because of a less agressive stance that improved future expectations. In extreme cases, the markets can force policymakers to change course.

Potential trades

The recent “mini-crisis” in the OAT-Bund spread might have reached a peak as policymakers started to take the problem very seriously. We’ve been seeing some steady tightening in the spread since Friday, which could be an early signal of a reversal. 

The euro and the CAC40 have been tightly correlated with the OAT-Bund spread since early September. The catalyst might have been the break of the 2024 low, which eventually led to a quick deterioration.

Chart: OAT-Bund spread (candles) vs EUR/USD (blue line – inverted) and CAC40 (purple line – inverted)

This morning French policymakers have doubled down on their committment to fix the problem and we’ve been seeing an acceleration in the spread tightening. This is leading to a rally in the euro and the CAC40. We could be in the early innings of a recovery…

This article was written by Giuseppe Dellamotta at investinglive.com.