In its latest report, Citi puts forward a view that differs from the mainstream market expectation: French public finance risks may constrain the European Central Bank from further tightening monetary policy. If fiscal pressure continues to intensify, the ECB may pause after a December rate hike; if financial stress spreads to other eurozone countries earlier than expected, the pause could come even sooner. The euro against the dollar may also fall below 1.10 as a result.

Citi rate strategists point out that the relationship between ECB rate expectations and the spread between French and German government bond yields has reversed, reflecting a shift in the market's attitude toward further monetary tightening. As French fiscal risks rise, investors may become increasingly worried that further rate hikes would worsen the tightening of financial conditions.

The currency market may be the first to reflect this change. Citi FX strategists believe that if the euro falls below the fair value implied by the two-year interest rate spread, the euro against the dollar could test 1.10. Citi's two-year valuation model shows that if the two-year spread between the eurozone and the United States narrows by 50 to 75 basis points, the exchange rate could fall to a range of 1.1075 to 1.1000, even without further deviation from fair value.

Citi lists going long on Federal Reserve rates and short on ECB rates as its preferred trade, essentially betting that ECB rate expectations will be revised down further relative to those of the Fed. Although the market has almost fully priced in a December ECB rate hike and factored in nearly two rate hikes by 2027, Citi believes French fiscal risks could prompt investors to reassess the ECB's policy path, leaving room for a 50 to 75 basis point adjustment in the related trade.

French Fiscal Risks Begin to Affect ECB Policy Expectations

Citi's core judgment is that French fiscal risks may influence the ECB's policy choices through financial conditions. As the risk premium on French government bonds rises, financing conditions across the eurozone may tighten. If the pressure spreads further to other highly indebted member states, the cost of continued ECB rate hikes will also rise.

This means that even if inflationary pressure persists, the ECB may not continue raising rates as the current market expects. Financial market volatility triggered by fiscal risks could become an important variable affecting its policy path.

Narrowing Spreads May Push the Euro Toward 1.10

Citi expects that ECB rate expectations relative to those of the Fed still have room to be revised down by 50 to 75 basis points. According to its two-year valuation model, if the two-year spread between the eurozone and the United States narrows by 50 to 75 basis points, the euro against the dollar could fall to a range of 1.1075 to 1.1000, even without additional exchange rate overshooting.

The key to this judgment is that the market is still pricing in further ECB rate hikes. If French fiscal risks prompt investors to lower their expectations for the ECB's peak rate, while Fed policy expectations do not change by the same magnitude, a narrowing euro-dollar interest rate spread could further weigh on the euro exchange rate.

Citi Bets on Lower ECB Rate Expectations

Citi's preferred trade strategy is to go long on Federal Reserve rates and short on ECB rates, betting that the rate expectation gap between the two will shift further in favor of the Fed.

Citi believes this strategy remains attractive even if the situation in Iran eases. A de-escalation of geopolitical tensions and falling commodity prices could support French equities, government bonds and the euro, thereby reducing the appeal of directly shorting these assets. However, the impact of French fiscal risks on ECB policy expectations may not disappear as energy prices fall.

Next, how French fiscal risks evolve and whether the ECB's December meeting will signal a slowdown in the pace of tightening will become important observation points for testing Citi's judgment.