From Paris and London to Washington, fiscal jitters are back

Global fiscal strains are slowly impacting capital markets, with French political gridlock and inefficient spending driving up sovereign spreads. The UK has a window to move closer towards fiscal balance and may take limited steps. But in developed markets including the US, rising debt costs and policy uncertainty may lift the premium demanded for long-term bonds, steepen the yield curve and increase market volatility.

France’s 8 September vote of confidence in the government is unlikely to produce immediate financial instability, but does highlight the impact of policy failure on long-term capital costs in Europe. Yet France’s debt questions are less about the sustainability of its debt, and more the quality of its public spending and misused fiscal capacity. The French tax system is inefficient, with a social safety net that generates limited economic returns. A German-style investment-driven fiscal package would be welcomed by investors, and more productive.

We see three potential scenarios in the weeks ahead: the government is replaced by a new administration with the same fragmented parliament; or new elections are called, probably resulting in continued fragmentation, or the least likely result, status quo. None of these outcomes resolve underlying inefficiencies. France enjoys structural strengths in energy, and food for example, but lags in fiscal reforms. Realistically, the policy paralysis over public finances will persist, even if the political status quo changes. As a result, France’s deficit will stay high.

International bond investors already priced much of France’s political risk. But French sovereign spreads have widened with yields now exceeding those of Spain, Portugal and Greece, even though these countries have lower credit ratings. The French government bond spread with German Bunds reached more than 80 basis points (bps) last week, its highest level since December 2024. We expect spreads to remain wide and volatile, and think they could reach 100 bps if uncertainty lasts.

We see little likelihood that France’s political crisis and fiscal limbo turn into a financial crisis

However, while instability adds to the broader theme of rising capital costs across developed markets, just as nine months ago, we see little likelihood that France’s political crisis and fiscal limbo turn into a financial crisis.

On the face of it, France’s fiscal environment is worse than the US or UK. Its budgets are large, with little prospect of political compromise, and so no scope for raising taxes. This said, the French private sector – both household and corporate – remains relatively solid, with excess savings, in contrast with the US which has a twin – public and private – deficit.

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Sticking to the rules

Similarly to France and most advanced economies, the UK faces tough fiscal choices given spending needs and an ageing population. In contrast to France, the UK government has the parliamentary majority to pass its fiscal plans, but the government has consistently pledged to stick to fiscal limits while ruling out the main tools for imposing discipline, and instead may consider changes to inheritance, wealth or property taxes. This leaves the UK in a pattern of less-than ideal policy choices every six months, that do the minimum but keep the economy in a state of uncertainty.

Monetary policy offers some help. Interest rates remain high, and fiscal tightening and eventually lower inflation would allow the Bank of England to cut rates. We expect the BoE to revise growth and inflation forecasts lower following the ‘Autumn statement’. This could lead to larger interest rate cuts than markets currently anticipate. Slowing the BoE’s quantitative tightening (QT) programme would also lower long-term Gilt yields, otherwise, QT risks countering any effects from lower rates.

Gilts offer better value than European bonds

In these circumstances, we think Gilts offer better value than European bonds, favouring 5-7 year maturities, and with term premium normalising, we expect that longer maturities will outperform other major sovereigns. In currencies, we still expect broad-based US dollar weakness, including against sterling, but see limited GBP/USD upside. Still, we are more negative on sterling against the euro. With fiscal tightening, domestic growth should slow UK equities, despite some BoE easing and weaker sterling offsetting earnings-per-share (EPS) growth. Recent EPS revision momentum has faded, and we remain underweight UK equities. A potential surcharge on banking profits could add risks to the regional equity outlook.

Challenge to the Fed

Fiscal discipline is also in doubt in the US after July’s ‘One Big Beautiful Bill.’ Against a weakening job market and potential tariff-driven inflation, the Trump administration aims to control US monetary policy. The targeting of Federal Reserve board governor Lisa Cook is part of this effort. While the president’s rhetoric focuses on affordable housing, the Fed’s overnight rate doesn’t directly control long-term mortgage rates and risks raising interest rates set by bond investors. 

So far, market reaction has been contained, pending a potentially drawn-out legal fight over Governor Cook’s dismissal. Investors may be assuming Mr Trump will back down if bond markets show signs of stress, as they did in April.

Undermining Fed autonomy could steepen the yield curve more than we currently anticipate, and push the term premium higher

Our currently cautious US Treasury bond positioning within global fixed income reflects expectations of a persistently high term premium, or the additional return investors expect for holding longer-maturity bonds, and a steeper curve. Lower short-term rates, driven by Fed cuts, will push short-term yields lower, while longer-dated yield falls will be limited by inflation volatility, and fiscal dynamics. We expect 2-year US Treasury yields to reach 3.10% in 12 months and 10-year yields 3.9%, and prefer average maturities of 5 years. However, undermining Fed autonomy could steepen the yield curve more than we currently anticipate, and push the term premium higher. This would also weaken the US dollar further and weigh on US Treasuries, creating equity market volatility.

Rising capital costs

French political uncertainty, US debt and concerns over Fed integrity as well as UK fiscal tightening are, on paper, disconnected although they all point to the risks of the rising cost of capital. Bond markets are watching closely, although they have not yet reacted dramatically. In France, the political status quo is unlikely to resolve fiscal inefficiencies and French equity markets have held up better than the summer of 2024 (see chart 2). Questions around Fed independence will rumble on in the US until the president gets a board majority, the legal system objects or bond markets baulk.

In the UK, some fiscal equilibrium may slowly emerge through unambitious steps. With fiscal tightening unfolding, domestic growth should be a headwind for UK equities, despite some BoE easing and GBP weakness and we prefer to remain underweight UK equities. We continue to expect broad-based US dollar weakness, including against sterling. However, GBPUSD upside will likely be limited. In contrast, we are more negative on the outlook for sterling versus the euro, and expect EURGBP to move closer to 0.89 over the next year. We see scope for haven currency demand, in particular the Japanese yen, to pick up if uncertainty persists in France.