After France, is Italy next? Goldman Sachs flags bond risks as Rome's deficit widens

French debt turmoil has thrust Europe's fiscal pressures into sharp focus in recent weeks, but investors' attention is quickly turning to Italy amid contentious new government spending plans.

The Italian government will next week present a budget encompassing recently approved allocations to defense and energy, which are set to widen the country's deficit over the next two years and put Italy's debt-to-GDP ratio on track to become the highest in Europe, according to analysts at Goldman Sachs.

Filippo Taddei, senior European economist at Goldman, said the changes could heap further pressure on Italian government bonds ahead of next year's general election.

On Oct. 2, Prime Minister Giorgia Meloni's center-right government approved an extra 28 billion euros ($31 billion) in borrowing over the next two years for defense and energy spending. Although scaled back, the spending plans have raised Italy's 2027 deficit target to 3.4% of GDP, and its 2028 target to 3.2%. That's up from earlier April projections of 2.8% and 2.5%, respectively, and above Goldman forecasts.

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The measures — which are split evenly between defense and energy, with each worth about 0.3% of GDP per year in 2027 and 2028 — come amid rising investor jitters over runaway government borrowing across the continent.

French bond woes

Yields on French government bonds have surged to multiyear highs in recent days, as the country's mounting debt crisis fuels wider concerns about Europe's strained public finances.

France's benchmark 10-year OAT yield dipped 3 basis points on Friday to 4.85%, amid lower oil prices. Yields on 10-year Italian BTPs were last seen 5 basis points lower at 4.55%. The spread between 10-year German Bunds , the benchmark for eurozone debt, and Italian BTPs was about 108 basis points by 1:40 p.m. CET (7:40 a.m. E.T.)

Taddei said Italy's fiscal risk premia could rise ahead of the country's next general election, due no later than December 22, 2027, on the back of the widening deficit.

A close-run election could leave little scope for fiscal consolidation, as parties on both the right and left look to "add spending-supportive partners" to build viable coalitions, he explained.

"Looser fiscal policy, tighter financial conditions and a close electoral race appear poised to weaken the debt outlook after four years of fiscal consolidation," he said in a note Thursday.

'Significant upward surprise'

Italian lawmakers voted Thursday to overhaul the country's electoral process, switching from a hybrid model to a more proportional system. Meloni's right-wing coalition says the change will lead to more stable governments and avoid chaotic post-election dealmaking.

But left-leaning opponents said the changes are designed to help Meloni cling to power.

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Meloni's administration — which will deliver its final pre-election budget next week — has been praised for lowering the deficit, which reached 3.1% in 2025.

Bond markets, in turn, have rewarded the country's new-found political stability, with Meloni recently becoming the longest-serving Italian leader since the World War II.

The spending hikes comply with the EU's National Escape Clause, which permits member states temporary budget flexibility on defense and energy investments to address shocks caused by Russia's war in Ukraine and the Middle East conflict.

Still, Taddei said the new deficit targets are a "significant upward surprise".

"We find that higher fiscal deficits, in addition to rising yields, look set to put the debt-to-GDP ratio on an upward path until 2028, before stabilizing around 137% — the highest in Europe by then," Taddei noted.

"Higher yields provide a key challenge in the current environment, and we find that a structural shift to 10-year yields higher than 4% would likely set Italy's debt-to-GDP ratio on an increasing path beyond that."

'Difficult fiscal decisions'

Konstantin Veit, portfolio manager at PIMCO, said the recent selloff in global bond yields has renewed the focus on countries with relatively weaker fundamentals.

Veit noted that while French government bonds are widely held by overseas investors — leaving them more exposed to negative news flow — Italian sovereign debt, in contrast, is mainly in domestic hands, which is typically "a stabilizing factor."

"While Italy has higher debt, it has a stronger primary balance, a relatively favorable trajectory, political stability and a history of making the necessary adjustments," Veit said.

Compared to France, Italy overall seems in a "relatively better place" at this stage, he added, with "stronger fundamentals, a more straightforward political configuration, and a track record of taking difficult fiscal decisions."

But investors are already zeroing in on opportunities in Italian debt.

Reinout De Bock, head of European rates strategy at UBS Investment Bank, recently unveiled a short position in Italian BTPs, wagering that Italian debt could emerge as the next weak link in European sovereign debt.

"I think Italy maybe will catch up, and people will get more concerned about Italy as well at these higher yields, despite a lot of reforms that have been done in Italy," de Bock told CNBC's "Squawk Box Europe."