Bank Downgrades Trouble Markets

Market sentiments were further hurt by worries on Spain, Greece and the European banking sector as a whole. Moody's downgrade of 16 Spanish banks and the surging yield in bond auctions sent Spanish CDS to a record high of 552 bps as the benchmark 10-year yield continues to march toward the 7%-unsustainable level. Fitch downgraded Greece on risk of Euro exit.

Asian equities are broadly lower following the -1.24% fall in the DOW overnight while the dollar index is heading closer to its 2012 high of 81.78. Note that the yen is the biggest winner, overshadowing the dollar as markets are starting to expect additional easing from Fed due to global financial market risk and recent weak U.S. economic data.

Across-The-Board Downgrades
Moody's downgraded 16 Spanish banks, saying, "banks will continue to face highly adverse operating and market-funding conditions that pose a threat to their creditworthiness". The rating agency believed, "the Spanish economy has fallen back into recession in first-quarter 2012" and it does not expect conditions to improve this year. Banco Santander (SAN), SA and Banco Bilbao Vizcaya Argentaria SA (BBVA), Spain's biggest lenders, were cut 3 levels to A3. According to moody's, the downgrades were mainly driven by a reassessment of each bank's standalone credit quality, which is expected to deteriorate further in the coming year.

However, the downgrades also reflected an assessment of reduced support from the Spanish government for 5 banks. The downgrades also indicated that the reforms (including additional provision requirements for banks, availability of government capital injections, creation of a framework for “bad banks" and employment of independent audits) announced by the finance ministry are viewed as insufficient to stem the problems in the country's banking sector.

Fitch downgraded Greece's long-term credit rating from B- to CCC and cited that it, "reflects the heightened risk that Greece may not be able to sustain its membership of Economic and Monetary Union". The rating agency noted that the May 6 parliamentary elections and subsequent failure to form a government showed, "lack of public and political support" for austerity and bailout from the EU and IMF. And, "in the event that the new general elections scheduled for 17 June fail to produce a government with a mandate to continue with the EU-IMF program of fiscal austerity and structural reform, an exit of Greece from the euro would be probable".

Possible Alliances
The latest polling result indicated that the pro-bailout New Democracy party now has a two-point lead over the SYRIZA party. If that continues through the June election, the New Democracy party would be able to form a government with the Pasok party. A coalition government formed by these two parties is expected to be less aggressive in overthrowing the pre-agreed austerity measures and implies a lower chance of Greece's exit from the Eurozone. But again, the situation is far from certain and we'd like to emphasize again the possibility that the June election could be as indecisive as the lasst one.

Looking ahead, Spain and Greece will remain the focus of all markets. In particular, eyes will be on how quickly the Spanish yield jumps on this week's events. On the data front, German PPI and Canada CPI will be released.