MacroScope

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.

Big event overnight was the downgrading of France to Aa1 by Moody’s, bringing it in line with Standard & Poor’s which cut back in January. There are some funds (even in this age of AAA scarcity) which will only invest in top notch debt and take their cue to exit once two agencies have dropped that rating, but the immediate impact is unlikely to be dramatic. The euro has slipped on the news, French government bond futures have dropped about a quarter of a point and safe haven German Bund futures have edged up. “Although it’s not great, the market doesn’t seem too worried,” one trader said.

However, it does throw a spotlight on the gap between France’s economic health (lack of it) and the record low costs it can borrow at. We’ve written plenty of good stuff on this already and French finance minister Moscovici gave his response to us last night. Interestingly, it wasn’t an attack on the ratings agencies, which we’ve seen before from Europe in these circumstances. Instead, he said it was an alarm bell telling the government to pursue structural reforms and reaffirmed his commitment to meet budget deficit targets. He noted that France continued to enjoy record low yields after S&P cut early in the year. The only thing he really took issue with was Moody’s view of the large risks to France’s banks. It warned it could cut France’s rating further.

As the day progresses, thoughts will turn to Greece and this evening’s meeting of euro zone finance ministers. We’ve had a strong exclusive readout of what is likely – an endorsement in principle to unfreeze loans to Greece but a final go-ahead for December disbursement only after a few final reforms are enacted in Athens. Berlin has suggested bundling together the next few Greek bailout tranches in order to pay over 44 billion euros if a green light is given. Others want only the next tranche of 31 billion to be handed over at this stage. Either way, that will keep the show on the road but there is plenty more to be decided yet.

The day before an EU summit that probably won’t come up with anything decisive in crisis management. If that sounds rather underwhelming beware. There’s an awful lot of jockeying for position over when Spain will seek sovereign help, the Greek troika talks continue to look messy with time running very short and the leaders would be very well advised to demonstrate that their longer-term plans for closer integration are not running out of puff – item one on that agenda is getting plans for step one of a banking union back on track.

We could get a decent crack at this today with a number of EU leaders, including Angela Merkel, Spain’s Mariano Rajoy and Greek premier Antonis Samaras, gathering in Bucharest for a centre-right political congress.

On the jockeying front, German Finance Minister Wolfgang Schaeuble has called for a leap forward in euro integration, particularly in terms of fiscal union with a commissioner given power over members’ budgets. That’s going to prompt some heated debate in Brussels on Thursday/Friday with France, in particular, likely to be aghast.

Moody’s put Germany on notice that it might cut its credit rating and did the same for the Netherlands and Luxembourg. It cited a growing chance that Greece could leave the euro zone, and the contagion and costs that could flow from that, as well as the possibility that Berlin might have to increase its support for Italy and Spain. Both are self-evident risks and markets have not really reacted though it’s interesting timing that Spanish Economy Minister de Guindos is meeting his German counterpart, Wolfgang Schaeuble, in Berlin later. The Moody’s warning could also feed into darkening German public opinion about the merits of offering any more help to its sick partners.

German Bund futures opened just 10 ticks lower and European stocks edged higher after a sharp Monday sell-off. A jump in China’s PMI index has helped sentiment a little. The euro remains on the back foot but if it continues to fall that should actually help euro zone economies, making their exports more competitive. We’re programmed to treat government statements with scepticism but it’s hard to argue with the German finance ministry which said last night that the risks cited by Moody’s were nothing new and the sound state of German public finances was unchanged.

Nonetheless, reminders of the depth of the debt crisis are close at hand. So dislocated is the Spanish debt market that is hard to gauge what costs Spain will be required to pay at today’s T-bill auction because a combination of summer holidays and worries about the country’s finances mean trading has virtually dried up. With benchmark bond yields hitting euro-era highs on Monday, however, the debt sale of 3 billion euros in 3- and 6-month bills is likely to be expensive.
Also last night, clearing house LCH.Clearnet SA  increased the cost of using Spanish and Italian bonds to raise funds via its repo service, which could put further upward pressure on already surging yields.

Italy, rapidly moving centre stage after the euro zone’s failure to assuage markets with a 100 billion euros Spanish bank bailout, faces a crunch bond auction. Having paid four percent to borrow for a year yesterday, it is likely to fork out over five percent for three-year paper although the smaller than usual target of up to 4.5 billion euros means the sale should get away. It will also issue a smattering of 2019 and 202 bonds.

Technocrat prime minister Mario Monti’s honeymoon period is over with even some he would have considered allies decrying the slow pace of his reform programme. Already this week he has appealed to Italy’s fractious political parties for support in keeping the austerity show on the road.
Today, Monti hosts France’s Francois Hollande. They agree on a lot – the need for a stronger growth strategy, a banking union established sooner rather than later and a longer-term goal of euro zone bonds. Berlin, with the possible exception of the first goal, definitely does not.

Moody’s slashed Spain’s rating to just one notch above junk last night. The power of the ratings agencies to shock is significantly diminished but if Spain’s sovereign rating drops further, more of whatever non-Spanish bank private investors are left will be forced to head for the exits. Moody’s noted that the bank bailout will increase Spain’s debt burden and the dangerous of loop of damaged banks being the main buyers of Spanish government debt which is falling in value. It repeated its warning that euro zone ratings could be cut further if Sunday’s Greek election were to increase the chances of that country leaving the euro.

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.