It has been a busy weekend for Wall Street, which has been doing all it can to spin the S&P downgrade in the best favorable light, although judging by the initial EURUSD and EURJPY reaction, so far not succeeding. Below we present a quick report written by Goldman's Lasse Nielsen on why in Goldman's view the downgrade's "impact is likely to be limited" and also the quick notes from an impromptu call MS organized for institutional clients (which had just two questions in the Q&A section, of which only one was answered - it appears virtually noboby believes that global moral hazard will allow anyone to fail at this point, so why bother even going out of bed).
From Goldman:
European Views: Euro area countries' credit rating downgraded: Impact likely to be limited
On Friday, January 13, S&P downgraded the credit rating of several Euro area countries. The downgrade was broadly anticipated by the market following S&P’s warning on December 5. We expect the direct impact of this downgrade to be limited. As we recently argued (see European Weekly Analyst 12/1, January 6, 2012), further difficult and controversial political decisions are needed in the coming months to stabilise the outlook for Euro financial markets and the Euro area real economy. The signal that Friday’s rating downgrade sends – together with a renewal of financial market tensions in general – may be the necessary catalyst for such an outcome to occur, although with the potential to inflict further damage on Euro area growth (particularly in Q1) in the meantime. Our base case remains that we should see some stabilisation of financial markets in the second half of 2012 as more clarity on the Euro area’s institutional framework emerges.
S&P lowered the long-term rating of Cyprus (to BB+ negative), Italy (BBB+ negative), Portugal (BB negative) and Spain (A negative) by two notches, while Austria (AA+ negative), France (AA+ negative), Malta (A- negative), Slovakia (A stable) and Slovenia (A+ negative) were downgraded one notch. The negative outlook means that there is a 1-in-3 chance that the rating will be moved lower again in the next 24 months. The move to downgrade several Euro area countries was mainly a result of S&P’s view that policy measures taken thus far to address the Euro area debt crisis are insufficient. S&P cited tightening credit conditions, rising sovereign spreads, economic weakness and political disagreement as reasons for the downgrade. Further, it was noted that the European rescue facilities were insufficient and that problems arising from external imbalances and divergence in competitiveness within the Euro area are not sufficiently recognised by recent policy initiatives. We have previously noted that the pressures in Euro area sovereign debt markets can only be tackled by a coordinated approach among member states. We discussed the issue of Euro area rebalancing recently (see European Weekly Analyst 11/39, November 17, 2011 and European Weekly Analyst 11/44, December 21, 2011), and noted that, with respect to external imbalances and total economy indebtedness, Italy and Ireland stand out as facing a relatively smaller challenge than if only public finance variables are considered.
We do not expect last Friday’s rating announcements to have a material impact on market pricing, given that the downgrade was largely expected. Specifically, we would note the following:
- The sovereign yield for France has been well above that of Germany for a while as markets have broadly treated France as a non-AAA sovereign. Friday’s announcement brings little new information in this respect. With only one rating agency downgrading France (and Austria) from their AAA-rating, the technical implications in terms of further increases in yield should be limited for now. We do not expect forced asset allocation flows resulting from this event, although market pressures for a policy response in France may remain in place. Also for this reason, our markets team recommended a week ago holding short positions in French 10-yr bonds against long positions in Italy (see Global Viewpoint 12/01, January 8, 2012).
- The effective EFSF’s lending capacity is currently determined by the amount of guarantees that AAA-rated countries have committed. With the downgrade of France and Austria, about €180bn of guarantees are no longer AAA-rated. This implies that either – if determined by the S&P rating – the capacity falls to about €260bn (in which case, depending on the size of the second Greek bailout, only about €70bn-€120bn of uncommitted funds remain) or the EFSF no longer attains a AAA-rating by S&P.
- What ultimately matters for the EFSF is not so much its rating, but its cost of raising funds. As the EFSF’s funding costs have been close to that of France anyway, the impact on the EFSF financing cost, as in the case of France, would likely be limited, were it not to maintain its AAA-rating by S&P.
- We think it unlikely that Germany would make up the ‘lost’ S&P rated AAA-guarantees of the EFSF. Instead, with the ESM scheduled to become active as soon as by mid-2012 and Germany’s commitment to fully pay in its share of the ESM capital before then, pressure to secure a similar commitment by other Euro area countries would likely occur. With a structure of paid-in capital, the ESM is less sensitive to the rating of its sovereign guarantors. The rating actions will likely further divert investors' attention to the ESM directly. Unless an arrangement to tap the ECB balance sheet is found, plans to ‘leverage’ the EFSF now seem more remote, as we have also commented before.
- With several countries being downgraded from already relatively low ratings, the risk of seeing larger haircuts in the ECB’s refinancing operations has increased, should similar downgrades occur by other rating agencies. Similarly, the risk of certain sovereign bonds not being eligible as collateral in the ECB’s refinancing operation has also increased. In such a situation, emergency liquidity assistance (ELA) conducted by the national central banks would likely be needed.
- As noted in European Weekly Analyst 12/1, a key impediment to further progress on the institutional front is France’s reluctance to give up further fiscal sovereignty. As France was downgraded, but Germany was not, on the margin, the cost of delaying agreement has increased, and likely relatively more so for France. As such, other things equal, this should increase the pressure to achieve agreement on further fiscal reform. As increasingly recognised since the start of the crisis, there is a ‘reflexive’ dynamic at play – market pressures or rating actions have generated a policy response and this is our expectation this time around too.
And our notes from the Morgan Stanley call:
Morgan Stanley
1. Impact on govt bond indices – initially trivial. Eligibility shouldn’t change for most. Portugal will be eliminated from several tracking funds.
2. Divergence in AAA space – there will be further divergence within core space in Euro sov market. If Fitch and Moodys follow S&P, average will eliminate France from indices. Possible reallocation out of France and Austria will likely benefit Germany. See further support for Bunds.
3. Selling flows – flows out of passive fund investors will likely be trivial due to limited impact on indices. But investors who follow AAA indices could be more active. Countries on neg outlook by more than two agencies are most of the core European countries.
4. Impact on Repo markets – downgrade will have no effect as all paper remains eligible. Portugal’s sov guaranteed paper will always be eligible as ECB has announced before. If Moody’s or Fitch downgrade Italy below A-, it will have adverse impact on Italian Repo market. Indications for other markets are mixed.
France may not be included any more in AAA benchmark will push Italy even further over AAA benchmark.
S&P’s decision is internally somewhat inconsistent according to MS. Germany is a benchmark and protected per MS: implication is that countries are weak if markets treat them as weak.
On Moodys, expect that rating agency will follow with whole set of downgrade. Believes most AAA govts will be downgrade.
Likelihood that pressure on sov ratings will remain across Europe.
Broad observations:
- Expect two notch downgrade for Italian banks, one notch for Spanish, and on French – SocGen to be downgraded to A from A+. Unicredit expected to be rated BBB- following rating action, but even so will have 8 notches as IG. UniCredit, SocGen and Intessa expected to come out of various tracking indices.
- Believe there should be no forced sellers on back of S&P downgrade ALONE. So once Moody’s joins in forced selling will begin?
- Risk of further downgrades of France will only accelerate.
Trading side observations:
- Italy remains a question mark on funding front following weaker auction last week
- Fitch and Moody’s will be critical: any S&P impact will be magnified. Market will try to predict what the other two will do.
- Germany non-downgrade is concerning as it would have killed AAA benchmarks. That they haven’t may mean some investors will remain in AAA benchmarks, benefit Germany, will lower weighing of France and Austria.
- Critical conclusion - one notch downgrade of France and Germany at AAA is more negative than 2 notch downgrade of France and if Germany had been downgraded by one notch.
Q&A:
Q: Impact on whether EFSF can support and ringfence Spain and Italy, and further concerns going fwd?
A. Thinking to EFSF and ESM, institutions and govts will have to decide whether they believe that they can operate as feasible issuers below AAA rating and raise funding that way, to support these borrowers. Leaving Europe with single pure A benchmark makes it harder as a AA-rated benchmark. Will make it harder for Euro sovs how to tackle this issue in the future, and mkt reaction will define decision to be made by sovereigns.
Q: On EFSF – with bonds trading at similar levels to French bonds, non-AAA entity, will there be a big impact?
A. MS can not answer the question.