MacroScope

Moments difficiles

Breaking news is S&P’s downgrade of France’s credit rating to AA from AA+ putting it two notches below Germany. Finance Minister Pierre Moscovici has rushed out to declare French debt is among the safest and most liquid in the euro zone, which is true.

What is also pretty unarguable is S&P’s assessment that France’s economic reform programme is falling short and the high unemployment is weakening support for further measures. There’s also Francois Hollande’s dismal poll ratings to throw into the mix.

As a result, medium-term growth prospects are lacklustre. Euro zone GDP figures for the third quarter are out next week and France is expected to lag with growth of just 0.1 percent.

French bond futures have fallen though not dramatically. They shrugged off the loss of France’s ‘AAA’ status nearly two years ago; yields are significantly lower now than they were then.

Last week’s upgrade of Spain’s rating outlook by Fitch was seen by some as a harbinger of better times. And given the work Madrid has done to increase competitiveness and cut labour costs, exports at least are on the up. France has travelled only a very little way down that road and we know from people right at the top of Europe’s policymaking tree that it is high on their worry list.

Possibility of Spanish downgrade looms over euro zone

Spanish government bonds have had a good run since the European Central Bank said it would protect the euro last year. But some analysts say the threat of a rating downgrade to junk remains an important risk.

Credit default swap prices are discounting such a move, according to Markit. Spain is only one notch above junk according to Moody’s and Standard & Poor’s ratings, and two notches above junk for Fitch. All three have it on negative outlook.  Bank of America-Merrill Lynch says it sees a “high probability” of a sovereign rating downgrade in the second half of the year.

As the table above shows, a cut to sub-investment grade would prompt Spanish sovereign debt to fall out of certain indices tracked by bond funds, resulting in forced selling, which could drive Spanish borrowing costs higher.

Spanish downgrade threat averted, but for how long?

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.”

Italy in market after Spanish downgrade

Italy is expected to pay slightly more than it did a month ago to borrow for three years at today’s auction of up to 6 billion euros of a range of bonds. Yields edged up at a sale of 11 billion euros of short-term paper on Wednesday but there is no immediate cause for alarm. Three year-yields have dropped from 5.3 percent to around 3.3 since the ECB declared its readiness to buy the bonds of troubled euro zone sovereigns and Italy has shifted about 80 percent of its debt requirements this year, so is on track in that regard.

The fact that it now seems possible that Mario Monti could continue as prime minister after spring elections can’t do any harm either although yesterday’s surprise cut in income tax muddies the waters a little.

The main problem for Italy is that Spain is in no rush to seek a bailout, a move that would alleviate pressure on Rome too. The IMF kept up the drumbeat of pressure for action in Tokyo, demanding “courageous and cooperative action”, having yesterday said the euro area was still threatened by a “downward spiral of capital flight, breakup fears and economic decline”.  German Finance Minister Wolfgang Schaeuble retorted that Europe was solving its problems and had done far more than appeared to outside observers.

Wall St. downplays downgrade. Will markets listen?

Reporting for this post was done by the U.S. markets team in New York.

A number of Wall Street analysts have reacted to the historic downgrade of the U.S. AAA rating on Friday evening with a shrug. Some argue the ratings firm’s warnings about the U.S. debt deal offered an early signal, while others dismissed the action, questioning the company’s record of giving AAA ratings to housing assets that turned out to be toxic.

Vassili Serbriakov, currency strategist at Wells Fargo in New York, said:

It’s not entirely unexpected. I believe it has already been partly priced into the dollar. We expect some further pressure on the U.S. dollar, but a sharp sell-off is in our view unlikely.

Paul Dales, chief U.S. economist at Capital Economics in Toronto:

I don’t think it will mean too much to be honest. There will probably be an initial market wobble — FX markets might struggle and Treasury yields might fall a bit. The bigger picture is really that the world is not much different.

U.S. downgrade could arrive as a whimper

A potential downgrade of U.S. Treasury debt by a credit ratings agency, once seen as impossible for the world’s largest economy, could resound in financial markets more with a whimper than a bang. That’s because, as was evident in a Reuters poll, investors have largely come to expect it.

That Standard & Poor’s ratings agency will cut the U.S. debt rating from AAA to AA+ is “the market’s base case at the moment,” said Krishna Memani, fixed-income director at OppenheimerFunds, with $188 billion in assets under management.

The market does not expect a significant, long-term deficit reduction plan that would keep S&P from cutting the U.S. debt rating.