The dollar gained strongly against the higher yielders overnight as a fresh bout of risk-aversion took hold.
The news that Moody’s may downgrade a slew of European banks because of their exposure to Eastern Europe caused the euro to fall off a cliff from 1.2765 to 1.2656 in a single hour. According to the report, “The recession in emerging Europe will be more severe than elsewhere due to large imbalances, and will put the financial strength ratings of local banks and their western parents under pressure. The combination of higher provisions for bad debt, the rise in banks' borrowing costs and falling currencies will weigh down banks' profitability and help erode their capital base."
The Polish zloty, Hungarian forint and Czech crown all fell to new lows against the dollar and euro.
The biggest exposure is by Austrian banks, which have lent the equivalent of 75% of its GDP to clients in emerging Europe. Belgium's, Sweden's and Greece's exposure is also substantial. The spread of Austrian and Greek 10-year bonds over German bunds widened to a lifetime high of 124 basis points and 300.8 basis points, respectively, on Tuesday.
Moody’s may downgrade Austrian, Swedish and other banks with subsidiaries in Eastern Europe, such as Erste Group, SocGen, KBC Groep of Belgium, UniCredit, and others. The MSCI East Europe Financials Index dropped 6.2% to the lowest in five years.
The consensus of opinion has the ECB cutting rates by 50 bp at the next policy meeting on March 5. Two-year note yields are about 75 basis points (bp) less than the ECB’s main refinancing rate after averaging about 30 bp more in the past 10 years. Further evidence comes in the form of the yield curve steepening; the spread between 2-year and 10-year Germany government paper widened to 198 bp last week from 82 bp a year ago (and 180 bp today). The average in the past five years is 72 basis points.