During the Asian session on Friday, October 23, EUR/USD traded slightly higher around 1.1220.
The European Central Bank's policy path and French fiscal risk remain the core variables determining the euro's medium-term direction.
Mitsubishi UFJ Financial Group (MUFG) expects the ECB to keep rates unchanged at next week's policy meeting, but believes the tightening cycle is not yet over, even though rising bond yields and French fiscal pressure have already done part of policymakers' work.
Core judgment: Hold in October, one hike each in December and Q1 2027
MUFG stated that the bond market selloff and France's growing fiscal risk have ruled out an October rate hike. ECB officials are increasingly pointing to the impact of tightening financial conditions on the outlook, while underlying inflationary pressures remain contained.
Nevertheless, the bank's strategists believe that resilient economic activity and higher natural gas prices since September still provide grounds for entering a slightly restrictive zone on risk management grounds.
MUFG expects the ECB to raise rates by 25 basis points in December and again in the first quarter of 2027, bringing the policy rate to 3.00%, before cutting back to 2.75% in the third quarter of 2027.
The core of this judgment is that the October pause is a pace adjustment rather than a directional shift. The ECB's tightening cycle is not yet over, but tighter financial conditions and French fiscal risk have already replaced policy action to some extent.
France is the core risk: Baseline scenario of fiscal drift
France is at the center of the outlook. MUFG noted that a divided parliament has led successive governments to repeatedly miss fiscal targets, and despite multiple consolidation plans, the deficit remains close to 6% of GDP.
Public debt stands at about 120% of GDP, and the bank says France has little room for further slippage and is highly vulnerable to weak growth or rising borrowing costs. The latest IMF forecasts already show France as a clear exception among major European economies, with growth projected at only 0.4% this year.
Bond market pressure is visible: the spread between French and German 10-year government bond yields has widened to levels not seen since the eurozone debt crisis, while France's annual interest expense has climbed to a record high.
MUFG believes that the high and rising share of French debt held by foreign investors may have amplified the selloff. So far, contagion has been limited, with Italian spreads relatively contained.
Four scenarios: Baseline is continued fiscal drift, EUR/USD range of 1.08 to 1.14
MUFG set out four scenarios ahead of the French presidential election, and named Le Pen as the frontrunner. Its baseline scenario (45% probability) is continued drift: the government relies on procedural mechanisms to keep functioning, measures are diluted or delayed, and the deficit remains between 5.6% and 6.0% of GDP.
In this case, MUFG expects the French-German spread to be around 170 basis points, with EUR/USD in a range of 1.08 to 1.14. This would not force an immediate ECB response, but quantitative tightening could come under scrutiny.
A deeper credibility crisis (15% probability) would bring severe political instability, recession, and a 2027 deficit well above 6%. This would push the spread beyond 200 basis points and drive EUR/USD down to between 1.02 and 1.10, with investors watching the ECB's Transmission Protection Instrument as a potential backstop.
On the more positive side, limited consolidation (35% probability) would keep the spread near 110 basis points, while faster consolidation (5% probability) would narrow it to about 90 basis points and support EUR/USD in a range of 1.12 to 1.18.
Euro forecast: 1.12 by year-end, recovering to 1.18 in Q3 2027
For the euro, MUFG said that the reduction in ECB rate hike expectations has already helped weaken the euro, and the euro is closely tied to the short-term interest rate differential between the US and Europe. The bank expects the dollar to remain strong for longer.
It forecasts EUR/USD at 1.12 by the end of this year, then gradually recovering to 1.14 in the first quarter of 2027, 1.16 in the second quarter, and 1.18 in the third quarter.
The core of this forecast is that in the short term, reduced ECB rate hike expectations and dollar strength will continue to weigh on the euro; in the medium term, as the ECB resumes hiking and dollar strength fades, the euro will gradually recover.
Market focus: Tone of the statement and press conference
With policymakers in a quiet period, next week's statement and press conference will be watched to gauge how much weight the ECB gives to tightening financial conditions and French fiscal risk, and whether it remains open to a December move.
The core of this focus is that the market will look for signals of a December rate hike in the ECB's wording. If the central bank expresses concern about tightening financial conditions, it could weaken expectations for a December hike; if it emphasizes inflation risks, it could strengthen them.
Summary
MUFG expects the ECB to keep rates unchanged next week, but the tightening cycle is not yet over. It expects 25 basis point hikes in December and the first quarter of 2027 to 3.00%, before cutting back to 2.75% in the third quarter of 2027.
The October pause is a pace adjustment rather than a directional shift, and tighter financial conditions and French fiscal risk have already replaced policy action to some extent.
France is the core risk. The baseline scenario (45% probability) is continued fiscal drift, with the deficit remaining between 5.6% and 6.0% of GDP, the French-German spread at about 170 basis points, and EUR/USD in a range of 1.08 to 1.14.
A deeper credibility crisis (15% probability) would push the spread beyond 200 basis points and drive EUR/USD down to 1.02 to 1.10.
MUFG forecasts EUR/USD at 1.12 by year-end, recovering to 1.18 in the third quarter of 2027.
The market will watch next week's statement and press conference to gauge the ECB's weighting of tightening financial conditions and French fiscal risk, and its openness to a December move.
At 7:37 Beijing time, EUR/USD was quoted at 1.1220/21.
Comments