The euro's ongoing slide has become another warning signal, with markets increasingly worried that France's debt situation could threaten the stability of the entire eurozone and pile more pressure on policymakers.

During Monday's European trading session, the euro briefly fell below $1.12 against the dollar, touching $1.1161, a 17-month low. The euro also weakened sharply against the pound, the Swiss franc and the yen.

Analysts said France sits at the center of current concerns in European financial markets, as the government seeks to push through an unpopular 2027 budget plan aimed at reducing the fiscal deficit and bringing its record-high debt under control. But with a deeply fragmented parliament, that goal is very difficult to achieve. And as political camps position themselves for next year's presidential election, France's domestic political uncertainty has risen further.

Risk-averse investors are selling French government bonds and buying German bunds, which are seen as safer. The extra yield premium investors now demand to hold French debt instead of German debt has climbed to its highest level since the 2010-2012 eurozone debt crisis. The currency market is therefore starting to worry that this pressure could spread further to other eurozone countries.

The risks facing Europe should not be underestimated: a region already struggling with weak economic growth is now being hit by political uncertainty. The party led by German Chancellor Merz suffered its worst local election defeat since World War II last month. On Monday, Spanish Prime Minister Pedro Sanchez announced an early general election, and Italy will also hold elections next year.

"Europe is in the market spotlight at the start of this week, with fiscal and political concerns hitting the entire eurozone," said Kathleen Brooks, research director at XTB. "France is at the center of current worries, but Spain will also hold an early election, which further adds to investor concerns."

At the same time, surging energy prices have pushed inflation higher, while rising bond yields are further increasing borrowing costs for households and businesses. If the euro continues to weaken, the European Central Bank could find itself in a dilemma: needing to contain inflation on one hand while stabilizing the bond market on the other.

Last week, the gap between French and German 10-year government bond yields widened to its highest level since 2012. Meanwhile, the spread between Italian and German bond yields briefly approached 130 basis points, marking the largest weekly increase since the COVID-19 crisis. Analysts warned that pressure in the French bond market could spread to other eurozone countries, raising fears of a repeat of the bloc's sovereign debt crisis in the 2010s.

Further downside risk

"The bond selloff is triggering broader volatility, and any asset the market perceives as vulnerable is being hit, which is also dragging the euro lower, and that selling momentum keeps building," said Kit Juckes, chief foreign exchange strategist at Societe Generale. Juckes added: "The factors that previously kept the euro above key levels against the dollar... I think they have disappeared." He was referring to the market's earlier view that the energy shock would be temporary and expectations that Washington wanted a weaker dollar.

Although the euro remains clearly above the 20-year low hit in 2022 when the Russia-Ukraine conflict broke out and Europe fell into an energy crisis, sharp swings in the bond market are adding a new factor to the euro's weakness. Bank of America currency strategists estimate that for every 10 basis point widening in the French-German bond yield spread, the euro could fall about 0.4% against the dollar. Goldman Sachs analysts said in a report: "Most of the time, the impact of spreads on exchange rates is close to zero, but during periods of severe market stress, that impact can rise significantly." They said: "Unless spreads become the only factor that matters, they usually do not really drive exchange rates." They also noted that when a risk event pushes German bond yields down while other eurozone countries' yields rise, the impact of spreads on the euro becomes even stronger.

Positioning data from the U.S. Commodity Futures Trading Commission (CFTC) shows traders are now betting on further euro declines, a view also reflected in the foreign exchange options market. Analysts said the euro could test the $1.10 level against the dollar. Juckes also pointed out that the euro faces significant downside risk against currencies such as the yen and the Swiss franc. In September, the euro had already fallen nearly 4% against the yen.

With the euro's decline occurring alongside stress in the bond market, the market has begun discussing how policymakers should stabilize financial markets, especially as the 2027 French election could further intensify market pressure. Stephen Jen, chief executive and co-chief investment officer of Eurizon SLJ Asset Management, said: "If Europe's fiscal contagion risk cannot be contained, I think the euro could still move lower against the dollar, even though it already looks somewhat undervalued from a valuation perspective."