By Yoruk Bahceli and Amanda Cooper

LONDON (Reuters) – The risk premium on French bonds dropped and bank stocks rallied on Thursday after a widely expected no-confidence vote toppled Prime Minister Michel Barnier's government, with focus turning to what a new government might look like.

Barnier is expected to resign later in the day and President Emmanuel Macron is hunting for a new prime minister, a day after opposition to Barnier's 60-billion euro ($63 billion) belt tightening effort led far-right and leftist lawmakers to vote his government out. That makes any meaningful progress towards closing France's budget deficit, which is set to top 6% of GDP this year, even less likely.

The closely watched risk premium France pays for 10-year government debt over Germany edged lower and briefly dropped below 80 basis points (bps), having touched 90 bps last week, the highest since 2012's euro zone debt crisis.

French stocks rose as much as 0.65% to their highest in over three weeks but trimmed gains thereafter and were last up 0.2% by 1219 GMT.

Shares in the country's lenders rallied, with BNP Paribas (OTC:BNPQY), Credit Agricole (OTC:CRARY) and Societe Generale (OTC:SCGLY) all up between 1.4% and 2.5%.

The euro was around 0.25% higher. "I would categorise the buying flows that I'm seeing…as short covering," said Amedeo Scippacercola, head of European government bond trading at Mizuho (NYSE:MFG). "People who bet on France widening the last couple of weeks, some of them are taking profits."

In another sign of stability, France raised 4.6 billion euros ($4.84 billion) from a longer-dated bond sale on Thursday, with demand in line with recent auctions.

UNCERTAINTY AHEAD

Thursday's relief rally doesn't reduce the uncertainty ahead for French markets. Macron is aiming to install a new prime minister swiftly, sources told Reuters, with one saying he wanted to name one as soon as Saturday. He will address the nation at 1900 GMT. "The market is reacting quite well to that," said Francois Savary, chief investment officer at Genvil Wealth Management.

French media reported that Francois Bayrou, a centrist Macron ally often cited as a possible successor to Barnier, will meet the president later on Thursday. In the meantime, far-right leader Marine Le Pen, the driving force behind government collapse, has said her camp would support an emergency law that rolls over the 2024 budget's tax-and-spend provisions into next year to ensure stopgap financing.

But any new prime minister will face the same challenges as Barnier in getting a 2025 budget adopted. There can be no new parliamentary election before July. "The market is asking whether the new prime minister is going to be perceived as market friendly or not, and is capable of passing a budget in a fragmented parliament," Mizuho's Scippacercola said.

Ratings agency S&P, which left its French rating unchanged on Friday, said a rollover of this year's budget was now the most likely outcome, adding that the country is left without a clear path towards reducing its deficit.

And while Macron not resigning was also supporting French bonds, "we are not out of the woods", said Barclays (LON:BARC) head of euro rates strategy Rohan Khanna, noting a majority of polled voters favour the President's resignation. The political backdrop in France has been fraught since June when Macron called the snap elections on June 9 that brought Barnier's minority government to power.

France's bond spread remains more than 30 bps higher since then, and French bank stocks are sitting on double-digit losses over the period.

"Depending on who will be heading this future government, markets may not see this eventually as a good thing,” said Kevin Thozet, investment committee member at French asset manager Carmignac, adding that he was staying away from French bonds and bank shares.

($1 = 0.9493 euros)