The third and fourth largest countries in the euro-zone may be next to receive downgrades. With the growing prospects of a Greek default and the turmoil in the markets, downgrades for Italy and Spain could happen soon and exacerbate the current vicious cycle in the debt crisis.
Everything seemed fine after the Greek vote. And then Portugal received a huge 4 notch downgrade by Moody’s. This sent the markets swirling. Portugal just received a bailout package two months ago. The reason for the move is likely to push other countries into the swirl.
Contagion I
Portugal was downgraded on the talks of private sector participation in Greek debt. This move didn’t seem voluntary to credit agencies, and they signaled that it would be a default. Such a default raises the risks for Portugal. S&P said selective default and Moody’s downgraded.
This pushed Italy’s fragile banking and political system into a mess. Italian bank stocks collapsed. Yields on Italian bonds soared. European officials got very angry at rating agencies.
Contagion II
An emergency / coordination meeting was summoned over the weekend, for Monday. The European finance ministers, together with senior European officials such as Jean-Claude Trichet and Jean-Claude Juncker, will discuss the Greek crisis and how a second bailout program will be made. Suddenly there’s not enough time until September.
According to the Financial Times, European leaders begin accepting a default by Greece. This was first bubbled by the Dutch finance minister Jan Kees de Jager who played down an option of a Greek default, in the wake of the rating agencies’ disapproval of the French plan.
Why go for a complicated plan if you get the same result with a simple restructuring?
Jean-Claude Trichet can shout again and again: no default, no selective default, no credit event. But even before this precedent happens in Greece, the rating agencies can act in their pro-cyclical manner and downgrade Italy and Spain.
Italy
Italy was recently warned. They have €69 billion to pay roll over during August and September. Paying higher yields or losing access to the markets is becoming real.
The political mess doesn’t help. The finance minister, Giulio Tremonti, which is highly regarded by the markets, is now under scrutiny for serious allegations of corruption. Prime Minister Berloscuni isn’t exactly at the peak of his carrier either.
Italian 10 year bond yields closed the previous week at 5.27%, already close to Spain.
Spain
The limelight has shifted away from Spain recently, but the troubles remain. The regions have known and also hidden debt that is beginning to surface.
The central government is doing a good job at reducing the deficit. But elections are getting closer. They are planned for March, but could happen earlier. The expected leader of the ruling socialist party, Alfredo Pérez Rubalcaba, already began his campaign. The current Prime Minister Zapatero won’t run once again, and is becoming a lame duck.
Spanish 10 year bond yields closed the previous week at 5.67%, touching the all time high.
Vicious Cycle
The bond vigilantes are raging and the rating agencies now follow. There are high chances of downgrades, and this will take its toll on the euro.
EUR/USD traded at a wide range in the past months, between hope and despair. The action will continue, with a tendency to the downside.
For more on the pair, see the euro dollar forecast.
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