A 180-degree turnaround
A 180-degree turnaround has occurred within the Eurozone between peripheral countries on one hand, and core and semi-core countries on the other, in terms of public finances. The situation is improving for the former while deteriorating for the latter. This divergence is particularly evident between France and Italy.
France has printed two consecutive years of significant budgetary slippage, leading to a public deficit of 5.8% of GDP in 2024, the highest ratio among Eurozone countries. Consequently, the primary balance (the budget balance excluding interest payments) is negative (-3.7% of GDP in 2024) and is the highest in the Eurozone, after Slovakia. The government targets to reduce the budget deficit to 5.4% in 2025, 4.6% in 2026, and below 3% by 2029. To achieve the 2026 objective, €40bn is required in savings, which is significant and particularly challenging in a context of a highly divided Parliament. Thus, the budget deficit will likely remain high, prompting rating agencies S&P and Fitch to downgrade French debt to A+, potentially as soon as the end of the year (the outlook attached to their current rating is negative).
The situation in France contrasts with the progress made by Italy on the budgetary front. Here, the deficit has decreased from 7.2% of GDP in 2023 to 3.4% in 2024, largely due to the gradual phasing out of the "superbonus," a tax credit for households for the energy renovation. The removal of this credit allowed the primary balance to turn slightly positive as early as 2024, and it is expected to improve further. The Italian government aims to reduce the public deficit to below 3% of GDP as early as 2026. Growth is expected to benefit notably from the acceleration of EU disbursements under NextGenerationEU. Unlike in France, and contrary to concerns that prevailed when Giorgia Meloni took charge of the coalition in September 2022, the Italian government is stable and focused on pursuing a prudent budgetary policy, which is congratulated in a rating upgrade by S&P in April 2025 to BBB+ from the previous BBB. Fitch and Moody’s may also upgrade their ratings, as their outlooks are positive.
This divergence in public finances is one of the elements supporting the convergence of Italy's spread, relative to Germany, and the French spread by the end of the year.
Beware of calm waters
The dissolution of France’s National Assembly in June 2024 by President Emmanuel Macron was unexpected by the markets and thus triggered significant uncertainty. The closely watched 10-year OAT/Bund spread reacted strongly to the news, widening first out to 80 basis points and then to 88 basis points by the end of the year with the fall of Michel Barnier's government (Barnier was Prime Minister of France from September to December 2024).
In 2025, the context has benefited France as the European Central Bank has continued to lower rates. Year-to-date, country spreads within the eurozone have tightened relative to Germany, France included. For France, the spread tightening has come despite a lack of improvement and visibility for the budget deficit. In addition, France has taken a back seat to other factors prevailing in the markets such as US tariffs ("Liberation Day“) and Germany’s announcement to launch a significant spending initiative. The 10-year OAT/Bund spread now trades at ~70 basis points, implying a lower political and budget risk premium.
In terms of flows, we note that “Fast Money” (futures positioning) has reduced its long positioning in France, whereas Asian investors (excluding Japan) are now back on the buy side in the primary markets, unlike in 2024. The eurozone is also benefiting this year from reallocations from the United States. The French bond market has notable structurally positive attributes: it is large, and liquid and it benefits from recurring structural buyers (insurers, pension funds, fund managers, and bank treasurers for high quality liquidity ratios).
We identify challenges for France on the horizon. In Q3 2025 budget discussions will take place with an objective to find €40 billion in savings. Reforms are clearly needed to reverse the deficit trajectory. There is also a non-negligible risk of a new government, and a Sword of Damocles is still present with the rating agencies indicating there is a high risk that France could lose its AA rating.
In this context, the 10-year OAT/Bund spread could widen out again to 80 basis points by year-end.
All roads lead to rome
Current market dynamics, characterized by narrowing spreads between Italian BTPs (Italian bonds) and German Bunds, create a favorable environment for investors.
Sovereign real rates have increased in the eurozone but are still ~100 basis points below the pre-pandemic average in Italy. Indeed, Italy benefits from significant support from the NextGenerationEU program, coupled with a primary balance that is coming back into positive territory, reflecting encouraging fiscal health.
Data on fund flows reveals increased demand for Italian debt from foreign investors. These same investors are marginal buyers of eurozone bonds, compensating for the decline in demand from European investors and ECB quantitative easing program. In addition, Italy is now a regular issuer of “BTP Valore” bonds targeted to retail investors, raising €25 billion year to date, following €29.5 billion in 2024.
Regarding future demand for Italian debt, it is important to note that there are still over €860 billion in current deposits, thus providing the government with the capacity to continue its retail issuances. Additionally, Italian investors hold about $55 billion in U.S. debt. Structural changes that we are currently witnessing also point to a potential reallocation of investments from U.S. assets to Europe which is supportive for Italian debt.
We also raise that a particularly relevant element is the existence of the Transmission Protection Instrument that was put in place by the ECB in 2022, which serves to support Italian spreads, ensuring greater stability for the market in times of uncertainty.
In terms of political risk, the situation in Italy appears less concerning compared to previous episodes of instability. The current political climate fosters a stable market environment, contributing to investor confidence.
These positive development will likely continue to support the compression of Italian spreads.
