MacroScope

Moody’s refrained from cutting Spain’s sovereign rating to junk territory last week, easing immediate fears that Spanish bonds could become vulnerable to forced selling if they fell out of benchmark indices, tracked by bond funds, as a result of the grade reduction.

But that risk still looms large.

Moody’s kept Spain’s rating at Baa3 but assigned it a negative outlook, saying ”the risks to its baseline scenario are high and skewed to the downside.” It said it believed the combination of euro area and European Central Bank support, along with the Spanish government’s own efforts, should allow the government to maintain access to capital markets at reasonable rates.

But should certain factors lead the rating agency “to conclude that the Spanish government had either lost, or was very likely to lose, access to private markets, then Moody’s would most likely implement a downgrade, potentially of multiple notches.”

Standard & Poor’s also has Spain one notch above speculative grade at BBB-minus, with a negative outlook.

Below are the potential implications of a Spanish downgrade, if it were to materialize:

It’s not a snap or even a pop – but there’s definitely a crackle. Rumblings emerging from key credit markets bare a frightening resemblance to the early days of the 2008 credit crunch.

Take commercial paper, a widely used instrument for short-term funding in the corporate world. Financial sector issuance of commercial paper fell steadily in the second half of last year, from around $556.5 billion in July to $434.4 brillion in December.  The final month of the year saw the downward trend spilling over into other industries.

Paul Ashworth at Capital Economics:

The contraction in commercial paper issued by the financial sector is now being compounded by a dramatic drop off in commercial paper loans to the non-financial sector.

Wall Street firms are begging the U.S. Treasury to take their cash, at least judging by the latest auction of short-term Treasury bills. Treasury sold $30 billion of four-week bills at a “high rate” (pause for laugther) of 0.000% on Wednesday, a mix of strong demand for year-end portfolio shuffling but also a reflection of ongoing fears of a credit crunch emanating from Europe.

It was the fourth straight sale in as many weeks that brought a high rate of zero. The zero percent rate means buyers of the debt will receive no interest at all, sacrificing any return simply to hold cash in the safest of investments.

A rise in repo financing costs is “a sign the year-end demand for short, safe assets has begun,” said Roseanne Briggen, our New York-based colleage at IFR Markets, a unit of ThomsonReuters.

The market for U.S. commercial paper, a key source of short-term funding for firms, is signaling fresh distrust of the banking sector. Investors continue to favor commercial paper issued by non-financial companies over those issued by banks, the latest Fed data show. On a non-seasonally adjusted basis, non-financial CP outstanding increased $5.1 billion to $187.1 billion in the week ended Sept. 21, while financial CP rose $3.2 billion to $503.5 billion. Since the end of 2010, the amount of industrial CP outstanding has grown by 65 percent, while the amount of bank CP has contracted by 10 percent.

Greece is in the danger zone. Even as the country’s finance minister sought to reassure his euro zone counterparts at a meeting in Poland, Greek credit default swaps were pricing in a more than 90 percent chance of default, according to Reuters calculations of Markit data. Economists in a Reuters poll see a 65 percent chance of that happening, probably within a year.

Such fears recently sent jitters across financial markets, prompting some words of comfort from German Chancellor Angela Merkel and French President Nicolas Sarkozy that they are determined to keep Greece in the euro zone. But speculation is growing that Greece will default, and that it will be a messy ordeal. Here are some of the potential dangers if it occurs:

* Greece may be seen as setting a precedent for Portugal and Ireland, analysts said. Yields on peripheral euro zone debt could surge rapidly, making funding costs increasingly unsustainable as yields on Italian and Spanish 10-year bonds surge back towards 7 percent. The ECB could have to intervene more aggressively in the secondary bond market to the detriment of its balance sheet.