By Stefano Rebaudo

(Reuters) – The risk premium investors demand to hold French debt rather than German Bunds dropped on Thursday after the widely expected collapse of the French government.

Far-right and left-wing lawmakers joined forces early this week to back a no-confidence motion against Prime Minister Michel Barnier.

Analysts fear France would enter a slow-burning crisis that could lead to a deterioration of sovereign creditworthiness and less economic growth.

They await the next move from President Emmanuel Macron, even if most analysts remained sceptical about a significant change of the current situation. Sources recently said he aimed to install a new prime minister swiftly.

> "We hold onto our conclusion that any French government from now until the earliest date at which a legislative election is plausible (September 2025, in our view) will operate in a context of political instability, very limited policy space, and persistent uncertainty about the medium-term policy outlook," Citi said in a research note.

In the draft budget bills, the outgoing government targeted 60 billion euros in spending cuts and tax increases to narrow the deficit to 5.1% of gross domestic product (GDP) in 2025 from 7.0% in a no-policy change scenario.

"Ultimately, the very likely extension of the 2024 budget to 2025 implies a fiscal policy that is less restrictive than planned in terms of tax revenues and in line with what was planned in terms of public spending," said Charlotte de Montpellier, senior economist, France and Switzerland at ING.

The gap between French and German yields – a gauge of the premium investors demand to hold France's debt – tightened 3 basis points (bps) to 80.60 bps. It hit 90 bps on Monday, its widest since 2012.

Given the price action in previous days, market participants had been expecting a muted reaction or even a 'buy on rumours, sell on news' response to the fall of the government.

"We expect its interest payments (on French public debt) to revenue ratio will reach 4.6% in 2025 and 5.2% in 2026, up from 4.4% in 2024," said Moody's (NYSE:MCO).

"A durable increase in financing costs would further weaken debt affordability despite the country's relatively long average maturity of 8.5 years," the rating agency added.

France raised 4.6 billion euros ($4.84 billion) from a sale of longer-dated bonds on Thursday, less than the maximum amount it was targeting.

Meanwhile, Germany's borrowing costs edged up, with investors waiting for jobs data from the U.S. later today and Friday, which could affect expectations for the Federal Reserve monetary easing path.

U.S. Fed Chair Jerome Powell appeared to signal his support for a slower pace of interest-rate cuts ahead.

Germany's 10-year government bond yields – the euro area's benchmark – rose one bp to 2.06%. It hit 2.033% last week, its lowest since early October.

"Valuations (with Bund yields at 2%) start to look stretched ahead of next week's likely 25 bps European Central Bank rate cut," said Hauke Siemssen, rate strategist at Commerzbank (ETR:CBKG).

Italian bonds slightly outperformed their German peers, with the gap between Italian and German yields hitting a fresh 35-month low at 110.40 bps.

Most of the yield spreads versus German Bunds have tightened as markets expect the ECB's significant rate cuts in 2025, which would ease the burden of debt for over-leveraged economies.