ECB leadership change may complicate response to French bond jolt: Mike Dolan

(Repeats with no changes) By Mike Dolan LONDON, Oct 6 (Reuters) — A euro crisis redux with France at its centre would demand a massive response from the European Central Bank to prevent spillovers and insulate the single currency. But a leadership switch at the top of the central bank is looming, which could both complicate that process and potentially raise the bar for action. Speculationkicked off early this year about current ECB chief Christine Lagarde's early departure before her term as president ends in October 2027, and it has never been fully put to rest.

The planned publication of her memoirs in January has been pencilled into many diaries, as it suggests she won't still be in the role when the calendar turns. If she does end up leaving by the end of this year, then two hawks — former Dutch central bank boss Klaas Knot and German Bundesbank chief Joachim Nagel — would be the leading contenders to be her potential successor. Theyshould instinctively be more wary of extraordinary ECB intervention than Lagarde or her predecessor. At the very least, the punned "Changing of Lagarde"is apt to come at an excruciatingly complicated time.

Even though the current French budget stand-off and the anxiety about the country'spresidential election in April have been brewing for well over a year, investors now appear to view the final quarter of 2026 as a starting gun for some dramatic repricing. France faces an ugly fiscal outlook. 5% of GDP, based on consensus estimates, pushing overall debt above the already hefty current year-end projection of roughly 120% of GDP.

Anxiety about the budget and political riskcaused the risk premium on 10-year French government debt over German equivalents to explode last week to the highest in 15 years — about 150 basis points, which is roughly where it was during the last euro sovereign debt crisis when Greece's debt load and teetering euro membership threatened to blow the single currency apart. We're not back in that territory — yet — but there is a major sovereign debt problem that has no clear solution. And it may not have for at least six months when the country elects a new leader.

Neither of the the two leading candidates vying for the Elysee next year — who are both situated on the far ends of France's wide political spectrum — are likely willing to back the sort of spending cuts required to bring the deficit down. Whether French risk spreads on this level will prove sustainable remains to be seen — and that's just the tip of the iceberg, as risk aversion in the interim could spill over to other euro sovereigns with less pressing budget problems than Paris. Some of that has already started to happen.

Debt spreads have widened in other markets such as Italy and Spain last week, with a commensurate rush to the relative safety of German bunds and even Swiss francs. If no solution is to be found domestically and market tensions persist and worsen, then all eyes will turn to a potential ECB rescue. The very first rung on that ladder would be to potentially pull back from further interest rate rises. The beginnings of that have already been seen, as markets no longer expect an October hike and are even questioning whether there will be another by year end— much to the chagrin of a euro knocked down to near 18-month lowsthis week.

But deflecting or delaying ECB tightening solves little and doesn't do anything to address what the central bank would see as fragmentation of the euro zone's lending markets that could threaten to undermines its ability to conduct monetary policy. To deal with that risk, it would have to turn to the Transmission Protect Instrument (TPI) — a tool created in 2022 aimed at buying bonds in the secondary market of countries who have been "unduly" hit by financial volatility, in the ECB's estimation. As the TPI has never been used, any move to do so would most likely have to be signalled in advance through ECB commentary and guidance, which could take some time.

It would also require deft consensus building amongst ECB policymakers who have frequently questioned the wisdom of endless debt market intervention over the past 17 years. Changing Of Lagarde Another option might be to halt the ECB's quantitative tightening programme, the running-down of assets on the bank's bloated balance sheet. 6 trillion left still amounts to some 44% of euro zone GDP — almost twice the share of US debt held by the Federal Reserve. Halting that run-off in response to debt stress may be an even higher bar for ECB hawks to vault than use of TPI.

Any action might be challenging before French elections. Barclays strategists, for example, reckon the ECB will likely hold back until it is clear who the winner is and what the post-election fiscal plans look like, especially if the winner is leading Far Right candidate Marine Le Pen. And yet that could be a long wait through a nervy year end — one that's now likely to contain a snap Spanish election on November 29 and US midterms earlier that month. Whatever route is chosen by the ECB, even if that's to stand still, will hinge as ever on the power of its leadership to bring the whole body along with it.

This has been the case in numerous episodes over the past 20 years, including the now famous "whatever it takes" speech by Mario Draghi in 2012. Even though Draghi may have been shooting from the hip during that key moment of the crisis —as he forcefully indicatedthat the ECB was willing and able to use its balance sheet to accumulate member states' bonds — he then spent years battling with German and Dutch hawks about use of what were then seen as controversial tools. If Lagarde does leave this year, the hawks may take over and the politics of consensus-building could become much more difficult.

Just as Federal Reserve Chair Kevin Warsh has questioned some of the excesses of post-crisis monetary policy, a new regime at the ECB could well be more averse to the use of extraordinary monetary tools that many hawks see as quasi fiscal policy. At the very least, pressure will build on Lagarde to make clear whether she's coming or going. "I can't get inside President Lagarde's head, but I do think it's important to clarify this matter," Italy's Economy Minister Giancarlo Giorgetti said late last week. Many in Paris might feel the same.

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