France's Fiscal Tightrope: Bond Market Vulnerabilities and Political Risks

The French government's proposed austerity measures, including the elimination of two public holidays and a freeze on public spending, have ignited a political firestorm. Prime Minister François Bayrou's budget aims to reduce the deficit to 4.6% of GDP by 2026, but its passage hinges on a fragile parliamentary majority. This precarious balance has sent ripples through bond markets, as investors weigh the risks of fiscal slippage against political instability. For investors, the interplay of these dynamics presents a compelling opportunity to position in short-term French bonds or hedge against widening credit default swap (CDS) spreads.

The Austerity Gamble and Political Fallout

The proposed cuts to Easter Monday and May 8—a day marking Victory in Europe—have been met with fierce opposition. The far-right National Rally and far-left Communist Party have condemned the measures as eroding France's historical and labor rights. This backlash underscores a deeper divide: the government's austerity agenda risks alienating both voters and lawmakers, with Bayrou's coalition lacking a parliamentary majority. A no-confidence vote could collapse the government, derailing the budget and reigniting fiscal uncertainty.

The stakes are high. Public debt stands at 114% of GDP, with interest payments projected to hit €100 billion annually by 2029. To avert this, the budget freezes public spending, delays tax adjustments, and imposes a “solidarity contribution” on high earners. Defense spending, however, will rise by €3.5 billion in 2026—a politically fraught trade-off that could further strain public support.

Bond Market Sentiment: Nervous but Not Yet Panicked

Despite the political risks, French bond yields have remained relatively stable. As of July 2025, the 2-year yield stood at 1.97%, down 0.04% from the prior session and 1 percentage point lower than a year earlier (). This reflects lingering confidence in the European Central Bank's backstop and the perception of France as a core Eurozone economy. However, the calm may be short-lived.

The real vulnerability lies in longer-dated debt. While the 10-year yield data is incomplete, historical trends suggest a widening gap between short- and long-term yields as investors price in political and fiscal risks. A prolonged stalemate over the budget could force yields higher, particularly if the government resorts to more aggressive austerity or defaults on its deficit targets.

CDS Spreads: A Hedge Against Rising Risk

Credit default swaps offer a direct play on France's creditworthiness. The 5-year CDS spread, a measure of perceived default risk, was at 0.59% as of January 2025 (). This remains low by historical standards, but political instability could push spreads upward. A collapse of the government or a failure to pass the budget would likely trigger a repricing of risk, benefiting CDS buyers.

Investors seeking exposure should consider long CDS positions, which profit from widening spreads. The CDS market's liquidity and leverage options make it a flexible hedge against French sovereign debt underperformance. Meanwhile, shorting French bonds—via ETFs like OLO (iShares EUR Government Bond 0-5Y)—could capitalize on a yield spike, though short-term bonds' lower duration offers better risk-adjusted returns amid uncertain volatility.

Investment Strategy: Position for Volatility

1. Short-Term Bond Exposure: Buy French 2-year or 5-year government bonds (e.g., FR0000120162) or ETFs tracking short-dated debt. These are less sensitive to long-term inflation risks but may rally if yields rise due to political instability.
2. CDS as a Hedge: Establish long CDS positions to profit from widening spreads. Monitor political developments closely; a no-confidence vote or deficit miss could trigger a sharp upward move.
3. Avoid Long-Dated Debt: The 10-year and 30-year bonds face heightened uncertainty. Their duration makes them vulnerable to rising rates and credit downgrades.

Conclusion

France's fiscal tightrope walk presents a test of political will and market resilience. While current bond yields and CDS spreads reflect a degree of calm, the risks of a government collapse or public backlash loom large. For investors, the asymmetry is clear: the potential upside in short-term bonds or CDS positions outweighs the downside of a stagnant market. As Bayrou's budget navigates the shoals of political opposition, now is the time to prepare for turbulence—and profit from it.