By Stefano Rebaudo and Tom Westbrook
(Reuters) -The euro was on track for its biggest monthly fall since January as political uncertainty weighed in the run-up to France’s general elections, while the dollar jumped to a near four-decade high against the battered yen ahead of key inflation data.
Investors fear that a new French government could increase fiscal spending, threatening the sustainability of the country’s public debt and the financial stability of the bloc.
At the same time, traders are cautiously testing Japan’s determination to protect its currency while keeping a keen eye on crucial U.S. inflation data.
The risk premium investors demand to hold French government bonds rose to its highest since 2012 on Friday ahead of the first round of voting for this weekend’s parliamentary elections, as investors expect a new government led by a far-right or far-left coalition to increase fiscal spending.
“The markets remain priced for a relatively benign scenario of a gridlocked legislature or a Rassemblement Nationale (RN) government, which only partially implements its manifesto,” said Aman Bansal, director of European rate strategy at Citi.
He added that the yield spread between French and German government bond yields – a gauge of French debt risk premium – now at 84 bps, could widen to 135 bps if the far right or the far left implements most of their manifesto and President Emanuel Macron resigns.
Barclays rate strategist Lefteris Farmakis flagged that for “every 15 bps of French yield spread widening versus Germany, the euro weakens by 0.5-1.0%.”
The euro was up 0.05% at $1.0707, and set to end the month with a 1.25% drop, the biggest since January, when it fell by 1.99%.
“Our euro zone team suspects it will be too early for a new government to substantially water down its pre-election pledges and that it may well be a rocky few months into September,” said Chris Turner, head of forex strategy at ING.
The yen hit 161.27 per dollar, its weakest since 1986, and was last down 0.14% at 160.52.
“Dollar-yen is very much U.S.-interest rate driven,” said Rong Ren Goh, a portfolio manager in the fixed income team at Eastspring Investments in Singapore.
“If the intent is to stall severe yen depreciation, they might also want to save bullets for occasion when and if U.S. Treasury yields stage another rally in the second half, which is highly possible against the backdrop of Treasury supply and fiscal deficit issues,” he added.
U.S. PRESIDENTIAL DEBATE
Republican U.S. presidential candidate Donald Trump unleashed a barrage of at-times false attacks on President Joe Biden in their first campaign debate in Atlanta, with the dollar rising as Biden stumbled over his words a few times in early exchanges.
That increased the odds of a Trump presidency and import tariffs, he said, noting traders were buying dollars but moves were fairly modest.
“A Trump victory is dollar-positive for several reasons, including a presidency that may be more aggressive on tariffs and could lead to more fiscal expansion, which is inflationary and would trigger higher policy rates,” Barclays’ Farmakis said.
The dollar index equalled Wednesday’s eight-week high of 106.13 and has logged a 1.5% rise for the quarter so far. It was last flat at 105.87.
It is the second quarterly gain in a row as markets have trimmed expectations for U.S. rate cuts over the past six months. The Federal Reserve’s preferred inflation measure, the personal consumption expenditures (PCE) index, is due later on Friday. If its annual growth slowed to 2.6% in May, as economists expect, it may open the way to cuts later this year.
The quarter’s biggest loser has been the yen, down 6% on the dollar since the end of March and more than 12% in 2024 so far.
Core inflation in Japan’s capital accelerated in June, data showed on Friday, though that did little to support the yen.
Low Japanese interest rates have encouraged selling yen for higher-yielding currencies even as Japanese yields have started to rise and officials have warned of another round of currency intervention.
Japan replaced top currency diplomat Masato Kanda on Friday with financial regulation expert Atsushi Mimura. Finance Minister Shunichi Suzuki said authorities were “deeply concerned” about the impact of “rapid and one-sided” yen moves.
