ECB set to pause in October, MUFG says, with two hikes still to come; EUR/USD seen at 1.12

The benchmark to watch is the 10-year yield gap between France and Germany: MUFG's base-case scenario places that gap at roughly 170 basis points, and a crisis scenario at over 200, readings last associated with the euro zone debt crisis. EUR/USD has moved in close step with the two-year euro-dollar swap spread. Any further trimming of ECB rate-increase expectations would probably hurt the currency, while a clear December signal could provide support. On the bond side, large redemptions from the ECB's holdings over the months ahead mean the speed of quantitative tightening is under scrutiny. Signs that the pace might slow could relieve French debt. Energy is still a wild card. MUFG's projections assume supply risks subside; if oil and gas prices stay elevated because of the Middle East conflict, both its rate outlook and its expectation of a gradual euro recovery would be tested.

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Earlier:

• ECB's Panetta: higher yields are a growth drag, not a crisis, ahead of rate meeting
• In its BoE preview, MUFG backs a November rate hike as the energy shock takes UK inflation above 4%

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Next week's ECB meeting should produce a hold, in MUFG's view, with higher bond yields and France's fiscal troubles already tightening conditions. The bank nonetheless expects two further rate increases and sees France as the biggest risk to the euro.

Summary:

• The bond sell-off and French fiscal risks have, in MUFG's assessment, removed the rationale for an October ECB hike, with officials stressing the drag from tighter financial conditions.
• MUFG still forecasts a 25 basis point increase in December, another in the first quarter of 2027, lifting the policy rate to 3.00%, and then a reduction to 2.75% by the third quarter of 2027.
• Solid activity and the rise in gas prices since September argue for a move into mildly restrictive territory as a risk-management step, while underlying inflation stays contained.
• The base case, assigned a 45% probability, is continued French fiscal drift: the deficit runs at 5.6% to 6.0% of GDP, the French-German spread sits near 170 basis points, and EUR/USD trades in a 1.08 to 1.14 range.
• In a more serious credibility crisis (15% probability), the spread exceeds 200 basis points and EUR/USD is seen between 1.02 and 1.10, with the ECB's Transmission Protection Instrument potentially in play.
• MUFG's year-end EUR/USD forecast is 1.12, with a slow recovery to 1.18 by the third quarter of 2027.

Rates are set to stay on hold at next week's ECB meeting, but MUFG contends that the tightening cycle still has further to go, even though climbing yields and France's fiscal problems are already tightening conditions for the bloc.

In its October assessment of Europe, MUFG said the sell-off in bond markets and rising fiscal risks in France had removed the possibility of a rate hike in October. ECB officials have increasingly pointed to what tighter financial conditions mean for the outlook, while underlying inflation pressures remain modest. Even so, MUFG's strategists think resilient activity and higher gas prices since September still warrant a small move into restrictive territory as a safeguarding measure. They expect a 25 basis point increase in December and a further one in the first quarter of 2027, which would bring the policy rate to 3.00%. After that, MUFG anticipates the ECB will lower the rate to 2.75% by the third quarter of 2027, a trajectory that depends on energy supply risks fading.

France sits at the core of the projections. MUFG points out that a divided parliament has made successive administrations repeatedly miss their fiscal goals, so the deficit remains close to 6% of GDP even after a number of consolidation efforts. With public debt at roughly 120% of GDP, the bank argues that France has limited space for more slippage and is very vulnerable to slower growth or higher financing costs. The most recent IMF projections already single out France as the obvious outlier among the major European economies, with output growth of only 0.4% expected this year.

The pressure is evident in bonds. France's 10-year yield premium over Germany has stretched to levels not seen since the euro zone debt crisis, and the country's yearly interest expense has reached a record high. Foreign investors hold a large and increasing share of French debt, which MUFG says may have made the sell-off worse. Contagion has stayed limited up to now, with Italian spreads remaining relatively contained.

Looking ahead to France's presidential election, MUFG lays out four scenarios and names Marine Le Pen the leading candidate. The base case, carrying a 45% probability, is continued drift: the government gets by through procedural devices, reforms are watered down or postponed, and the deficit remains in a 5.6% to 6.0% range as a share of GDP. In that situation, MUFG puts the French-German spread near 170 basis points and EUR/USD in a 1.08 to 1.14 band. The ECB would not be forced to respond immediately, but quantitative tightening might be reconsidered.

At 15% probability, a deeper credibility crisis would produce acute political instability, a recession and a deficit comfortably above 6% in 2027. The spread would then climb past 200 basis points, pushing EUR/USD down to a range of 1.02 to 1.10, while investors might view the ECB's Transmission Protection Instrument as a possible safety net. On the more favourable side, limited consolidation, given 35% probability, would keep the spread near 110 basis points, and faster consolidation, at 5%, would bring it to roughly 90 basis points and underpin EUR/USD in a 1.12 to 1.18 range.

On currencies, MUFG says reduced expectations of ECB tightening have already contributed to euro weakness, with the currency closely following short-term rate differentials against the US. The dollar is expected to stay firmer for an extended period. The bank puts EUR/USD at 1.12 at the end of this year, followed by a gradual recovery to 1.14 in the first quarter of 2027, 1.16 in the second and 1.18 in the third.

With ECB officials now in their quiet period, attention at next week's announcement and press conference will centre on how much emphasis the bank places on tighter financial conditions and France's fiscal risks, and on whether a December move remains possible.