| Implications of S&P's euro area downgrades |
| 16.01.12 12:25 | |
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We review our position on potential further downgrades and consider the market implications of S&P's downgrade of nine euro area countries on 13 January. Though S&P's action was reported to be primarily driven by the inadequacy of the euro area framework for dealing with the crisis, the downgrades were not uniform and some countries not downgraded (a bit of a paradox). This suggests to us that further rating action could rest as much on euro area policies as on the strengths and weaknesses of individual countries. S&P cited the euro area policy framework's focus on fiscal austerity, the lack of financial support to resolve the crisis, and the absence of measures to tackle uneven competitiveness across countries as reasons for its downgrades. With this background, the risk of further downgrades is biased to the downside over the next few months, as euro area countries try to beef up their fiscal and growth frameworks. In particular, for the EFSF to keep its own Triple A rating, a change in the guarantee structure will be needed. Bringing forward its successor, the ESM, would help, but that is set to be achieved only in July 2012. For individual countries, we see risks to their growth prospects and possible interest rate moves. We project small recession for most of the downgraded euro area countries, leading to further fiscal measures. Also, implementing structural reform to boost competitiveness is challenging in election years and higher growth can take time to materialise. Not all downgrades translate into higher borrowing rates, as demonstrated by the US following S&P's action in summer 2011, but there is a risk that rates may edge up for some countries. It is quite possible the rating action translates into higher rates and rate volatility on the sovereign bond markets while the negotiations over the Greek programme and private sector participation drag on. Against this backdrop, we would expect the ECB to use the securities market purchase (SMP) programme with a view to avoiding distortions to monetary policy transmission mechanisms, ie, to bring down longer term yields should they edge up. Overall, the downgrades, particularly if followed by other ratings agencies, are negative for investment flows into the euro area and therefore a further blow for the euro. Hence we expect EUR-USD to continue to weaken - our end Q1 forecast is $1.25 and carries significant downside risk. Implications for indices. Subsequent to S&P's downgrade, the average rating of Spanish bonds (from the three major agencies) will drop from AA- to A+. As a result, Spain should leave most "AAA-AA" and "AA" bond indices at the end of the month. It will take another downgrade for the average rating of French bonds to drop below AAA. source: Bank of America ML |
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