Fundamental Update: Do Ratings Downgrades Matter?

The downgrade of nine Eurozone members on Friday was headline news around the world. Some elements of the British press wrote with glee that France had been downgraded one notch to AA+ by Standard & Poor’s while the UK remains tripe A. However, the question now for FX investors is: do these downgrades matter.

Obviously France still has an impressive credit rating (very impressive since France is expected to have a budget deficit of nearly 6% of GDP for 2011 and total government debt of more than 85% of GDP), and the market was well prepped for a French downgrade. Italy’s two-notch downgrade by S&P is more worrying. It is now in the BBB+ bracket, three notches above junk status. Portugal may have been downgraded to junk, however changes to the ECB rules means that Lisbon’s debt can still be posted as collateral with the Bank in return for its cash.

The EFSF rescue fund is still on negative watch and we need to wait to see if S&P also gives it the chop post the conclusion of its review. Since France makes up one-fifth of the funding guarantees for the EFSF it is hard to see how it can hold onto its triple A status in the long-term. However, Germany retained its top credit rating and since we all know the future of the Eurozone now rests at Germany’s door, this could help the fund to avoid a downgrade.

The S&P said that more downgrades are likely unless a policy response to this crisis is found swiftly (unlikely), which leaves Italy looking very vulnerable. The other point to note is that banks are also affected by these downgrades. Since banks in Europe hold so much sovereign debt, downgrades mean that they have to post even more collateral to secure funding (even if it is from the ECB), which further hinders banks’ ability to make loans to the wider community. Already, French banks have said they have reduced the amount of credit they offer to their customers, which poses a risk to growth in the region. This then weighs on a country’s ability to fund its debts, making it less creditworthy – so Europe is now in a negative feedback loop that could have nasty economic consequences.

But what does this mean for the euro? A reduction in the credit-worthiness of debt that banks hold makes them even more reliant on the ECB for funding. The ECB’s balance sheet is already bigger than the Fed’s and the BOE’s at EUR 2.73 trillion, and it is only going to continue to expand as new ECB President Draghi seems more than willing to ensure banks are awash with liquidity. A balance sheet expanding at the pace of the ECB’s is not good news for the euro and we expect the currency to embark on another leg lower as a result of these downgrades. Indeed at the Asia open earlier the euro fell and we expect it to continue to weaken especially against the pound and the dollar.

EUR/JPY is trickier. The Japanese finance minister said this weekend that France’s downgrade could cause the spotlight to turn to Japan. The question now is can the yen continue to act as a safe haven if another downgrade is on the cards for Tokyo?

Overall, a weaker euro is a good thing for the Eurozone economy as it tries to export its way out of this crisis. The impact on bond yields could be more muted. Back in August the ratings downgrade to the US didn’t stop Treasury yields hitting record lows 6-weeks later. Added to that the ECB will still provide banks with funding even with lower grade sovereign collateral, so the downgrade may not spark forced selling in the bond markets. But we will get confirmation of the impact on debt markets tomorrow when France goes to market.

The other development on Friday that could be more catastrophic for the currency bloc was the breakdown in talks between private sector bond holders and the Greek government. Athens needs to get private sector bond holders to accept losses on their investments in order to get its next instalment of bailout funds so that it can meet a bond redemption of more than EUR 14bn on 20th March. Time is running out. A deal needs to be agreed in the next few weeks to ensure all of the paperwork is ready by 20th March. If not then a disorderly default from Athens and a break-up of the Eurozone are on the cards.

Private sector investors – mostly hedge funds and banks – want the ECB to take losses as well. The ECB is not part of the private sector so it hasn’t been involved in the PSI discussions. However, we think some ECB involvement is necessary to 1, get agreement from other investors to accept losses and 2, get a firm commitment that PSI won’t be inflicted on the holders of other Eurozone debt. So Greece’s survival in the currency bloc could depend on the ECB.

As if we didn’t have enough to concern us with Europe, the Fed’s Charles Evans struck a very dovish note in a speech at the weekend. He expressed doubt that the US unemployment rate will continue to improve and noted that the economy remains on shaky ground. However, he is the most dovish member of the US central bank and is a lone voice calling for more QE to the tune of $600bn, specifically targeting mortgage-backed-securities.

And political risk is also heating up in the US that investors need to keep an eye on. The payroll tax cut extension expires at the end of February. If Congress can’t agree on a long term extension (at the end of Dec it was only lengthened by two months) then sentiment in the US could drop off causing another bout of volatility in the market.

Of more immediate impact this week will be the French debt auctions and inflation data in the US and UK. We expect the German ZEW survey of investors to remain decidedly glum. So it could be the seventh straight week of losses for the euro and we remain cautious on all risky assets as we start the week. But stretched euro positioning could mean that the single currency has some sharp short-covering rallies after every 80-100 pip decline or so, so watch out.

It will be interesting to see if the commodity bloc currencies can break away from the euro this week. The Australian Treasurer said that the Eurozone downgrades serve to highlight the sound public finances in Oz. However, the lack of liquidity in the commodity bloc is likely to stymie any attempts for it to become a safe haven at least in the medium-term.