France’s back-to-school blues, ECB on hold and no summer break for the trade war

La rentrée kicks off with another confidence vote on 8 September following the political deadlock over the 2026 budget. Prime Minister Bayrou’s government is unlikely to survive, making a watered-down budget (EUR20bn vs EUR44bn originally) the most likely outcome by the end of the year, though  the streamlining of public agencies, tighter control of healthcare spending, lower transfers to local governments and reduction or removal of inefficient tax loopholes should remain. The OAT spread would settle at around 80-90bps, while France’s budget deficit would likely settle at around -5% of GDP in 2026 even if the next government resorts to a Special Law instead of passing a formal budget. The worst-case scenario (15% probability) would be new snap elections, which could hit growth hard amid tighter financing conditions (OAT spreads at 100-110bps) and keep the deficit at around -5.4% next year. But if French spreads hit 100–120bps, the ECB would likely slow down or halt its current pace of quantitative tightening (QT), and a move towards 120–150bps could trigger the Transmission Protection Instrument (TPI), which would bring spreads back to the 80-90bps range.

The ECB is expected to keep policy rates unchanged at 2% at its next meeting on 11 September. Given the recent uptick in inflation, fading uncertainty around the trade war and a closing window for fiscal-stimulus-fueled growth from Germany, we have now removed the two additional rate cuts that had been penciled in after Labor Day. While there remains an economic justification for modest additional easing, ECB communication has turned markedly more hawkish since the last policy meeting: In the absence of a major shock, the current policy stance will remain unchanged. Nevertheless, the Eurozone continues to face mounting challenges, including rising financing costs amid elevated fiscal deficits and growing political and economic fragility in core economies – notably France and Germany. In essence, we are revising our baseline from anticipating further monetary easing – with risks tilted to the upside – to expecting no additional cuts, with risks now skewed to the downside. The continued rise in long-end government bond yields will likely reignite the debate over the pace of quantitative tightening.

Companies continued to diversify supply chains, resulting in the US importing less from China (9% of total in July 2025 vs. 14% in 2024) and more from lower-tariffed markets (Southeast Asia, India and Taiwan, together 24% in July 2025 vs. 17% in 2024). Consequently, in July, the effective tariff rate collected was lower than expected, at 10%. But it could reach 14% as soon as September – compared to 17% without firms’ mitigation strategies – given limited room for further supply-chain diversification (without major investment pledges), and higher tariffs kicking in since the summer trade deals. Moreover, uncertainty persists as several Section 232 sectoral investigations need to be concluded by year-end. Hiking tariffs by +25pps on all products currently under investigation could further raise the US tariff rate by up to +3pps. Meanwhile, if approved, the EU-US deal should ultimately bring the US tariff rate on the EU to 12% and potentially help the EU recover US market shares lost so far this year (-2pp), notably on aircraft & parts and semiconductor equipment. But some concessions could stand in the way of the EU’s own ambitions in defense procurement, data privacy, emission reductions and energy procurement.