MacroScope

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 euro zone and IMF are at odds over whether to give Greece an extra two years to get its debt/GDP ratio down to 120 percent – the maximum the IMF has decreed can be viewed as sustainable. The Fund insists the 2020 date be stuck with. It has also been keen for euro zone governments to take a writedown on the Greek bonds they hold, as private creditors did earlier this year. But Germany and others insist this would be illegal.

Furthermore, we know the euro zone is looking at a deal to sort out Greece only for the next two years – presumably recognizing that tougher, longer-term decisions will not be politically possible before German elections in just under a year – while IMF chief Christine Lagarde has consistently called for a permanent solution to be reached now. If the IMF walked away, it would be a disastrous credibility blow for Europe and one which could prompt the sort of market attack not seen since the ECB came in with its “we’ll save the euro whatever it takes ” gambit.  So the working assumption has to be that a deal will be done which the Fund can live with.

The law of diminishing returns?
The first euro zone bailout, of Greece, bought a few months of respite, the next ones bought weeks, latterly it was days. Now … hours. Spanish bond yields ended higher on the day and, more worryingly, Italy’s 10-year broke above six percent. It was always unlikely the deal to revive Spanish banks was going to lead to a durable market rally with make-or-break Greek elections looming on Sunday but there were other things at play.

Top of the list is that the bailout will inflate Spain’s public debt and the dangerous loop of damaged banks buying Spanish government bonds that are falling in value. There’s also the fact that Germany and others are keen to use the new ESM rescue fund to funnel money to Spain because of the greater flexibility it offers. That will make private investors subordinate to the ESM which could prompt another rush for the exits which Madrid can ill afford since this is the first euro zone bailout which keeps the recipient active in the bond market.
It’s for the same reason that a revival of the ECB’s bond-buying programme, which it still doesn’t fancy, could prove counter-productive.

Officials are already pondering that conundrum, suggesting that the loan to Spain could initially be made under the existing EFSF bailout fund then taken over by the ESM, though that sounds like the sort of creative thinking in Brussels that generally fails to convince investors.
Another cracking Retuers exclusive following our breaking of the Spanish bailout on Friday, showing European finance officials have discussed limiting the size of withdrawals from ATM machines, imposing border checks and introducing euro zone capital controls as a worst-case scenario should Athens decide to leave the euro, is unlikely to have settle market nerves.