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.

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.

Steps forward and steps back…

The Netherlands’ fractured political class managed to unite enough last night to reach a deal on a 2013 budget which they say will cut the deficit to 3 percent of GDP as required by new EU fiscal rules. Failure could have undermined the EU fiscal pact before it was even born and undermined the efforts of Italy and Spain to pull clear of the debt supernova.

Shortly afterwards, Standard & Poor’s  put the boot in by downgrading Spain two notches to BBB+, saying it could cut the rating further. Most tellingly, it cited the increasing likelihood that the government will have to provide further funds to the banking sector which is beset by property bad debts. Madrid insists it will not have to do so, nor will it look to the euro zone for help. Something will have to give since there is no prospect of troubled banks raising capital themselves.

However, S&P did note the structural reforms already undertaken which should support growth in the long-term and the fact that the ECB’s three-year money operation had reduced the banking risk for now.

S&P on Monday cut Greece’s ratings to “selective default” but said it would consider the default “cured” after Greece completes its debt exchange. At that point, S&P plans on upgrading the country to CCC. Here is the full statement S&P issued alongside the decision:

Standard & Poor’s Ratings Services said today that it has lowered its ‘CC’ long-term and ‘C’ short-term sovereign credit ratings on the Hellenic Republic (Greece) to ‘SD’ (selective default).

Our recovery rating of ’4′ on Greece’s foreign-currency issue ratings is unchanged. Our country transfer and convertibility (T&C) assessment for Greece, as for all other eurozone members, remains ‘AAA’.

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.

Standard & Poor’s on Friday downgraded the United States’ prized credit rating, a move that is likely to compound recent instability in financial markets. Here is S&P’s statement explaining the decision:

United States of America Long-Term Rating Lowered To ‘AA+’ Due To Political Risks, Rising Debt Burden; Outlook Negative

We have lowered our long-term sovereign credit rating on the United States of America to ‘AA+’ from ‘AAA’ and affirmed the ‘A-1+’ short-term rating.

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.