CME: S&P downgrades were a "non-event" for many

Euromoney Skew

January 23, 2012

The Chicago Mercantile Exchange says the range of country and EFSF downgrades were actually "non-events" - due to the markets already pricing in these moves in anticipation of a credit rating slash.

Just last week, credit ratings agency Standard & Poor's (S&P) downgraded the sovereign debt credit of nine countries, including stripping France of it's coveted AAA status.

Subsequently, the European Financial Stability Facility (EFSF), which has always been at pains to emphasise that its creditworthiness is based on the value of the guarantees provided by its AAA constituents, was downgraded on January 16 and the question is whether Moody’s and Fitch will downgrade it too:

That depends on their view of France, which contributes 21.83% of the facility's guarantees.

Moody’s has the country on a stable outlook but will review and update this during the first quarter of this year. Fitch has France on a negative outlook, which Rabobank analysts believe means there is a 61% chance the agency will downgrade by August 26.

However, this does not spell immediate disaster for the fund.

“This points to more peripheral tension as the safety net becomes weaker and will drive efforts to bring the ESM forward in order to take the EFSF out of the picture altogether. S&P is only one of three agencies," says Richard McGuire, senior fixed income strategist at Rabobank in London. "Logically one would expect that a downgrade by two agencies would be needed for the EFSF to lose its AAA status."

Source: CME

After downgrading long-term ratings of the EFSF to AA+, "the rationale was that 2 of the guarantors, France and Austria had lost their previous AAA ratings. S&P's assessment of the EFSF‟s short-term debt was, however, reconfirmed at A-1+.2 Appendix A lists the ratings and outlook classifications for the affected eurozone countries," says the CME.

Well, of course, judging by the headline events, it would seem that there was some sort of element of surprise - maybe not on the credit worthiness of the countries and fund in question, but more to do with S&P taking the plunge and slashing the ratings that many previously though would be too difficult to make official.

However, the CME put out an interesting research note on how the raft of credit ratings downgrades has been more of a damp squib for the markets.

In the note on Monday, the CME said (emphasis ours):

Actually, this was considered a “non-event” in some circles as financial markets had previously built such an expectation into market pricing. France‟s debt ratings in particular, had become the subject of much scrutiny in recent weeks.

Still, S&P‟s action represents an important milestone to the extent that it provides formal recognition of the deterioration in confidence in the principal players in the ongoing eurozone sovereign debt crisis. It is further indicative of the general apprehension that the situation could be “viral” – possibly spiraling into a contagion scenario worse than the previous flare-ups of 2010 and 2011.

Certainly S&P‟s action reflects a fundamental shift in global attitudes regarding risk with a growing adversity towards “developed world” assets, i.e., developed countries are no longer “risk-free.”

The formal recognition of the "deterioration in confidence" is highly important.

During 2011, many market participants exclaimed how France was unlikely to be downgraded – not because it doesn't deserve to be, but mainly because of the political implications behind this.

Furthermore, a conflict of interest has been called into question, which led many to say that having a country like France being downgraded would be very slim:

“There is a general market perception that at times there can be a conflict of interest because the companies or sovereigns who want to be rated are paying the agencies to grade them. This obviously includes auditing their accounts.”

However, also notably the CME recounted the current situation and has assessed possible implications for market participants in CME Group markets, which includes bonds and foreign exchange.

Here are some edited highlights:

Impact on Bond Markets

The S&P downgrades may be dismissed by some market participants as unimportant but we believe the actions have had immediate impact on certain vulnerable countries, specifically Portugal and Italy.

With its sovereign credit rating downgraded from BB from BBB-, or “junk” status, Portugal encounters serious knock-on effects, exacerbating an increase in its borrowing costs and the probability of default.

Its BB rating is now on par with the likes of the Philippines and Turkey. But, while Turkey and Portugal may be par in the ratings, Turkey has advanced 4 notches in the past decade, while Portugal‟s rating is heading south.

As Portugal edges towards default territory, many funds are compelled to sell Portuguese bonds. Other investors sold Portuguese debt after Lisbon was removed from Citigroup‟s European Bond Index. Not surprisingly, the price of credit default swaps (CDS) on Portuguese sovereign debt jumped over the past week and now reflects a 65% chance of default over the next five years.

Source: CME

And in currency - the CME says that the "Euro/U.S. dollar (EUR/USD) futures contract is the most obviously impacted of all our markets."

"The Euro declined dramatically during 2010‟s sovereign debt episode, which decline was stemmed with the IMF/EU €110 billion bailout package. After a recovery in late 2010 through early 2011, the Euro has tumbled from a rate of almost 1.50 Euros per USD to current levels near 1.25," it adds.

However, all eyes have turned towards Davos, as the European sovereign debt crisis is naturally the focus for all - especially Greece where disappointment over the lack of a deal has hit the markets.

"It remains unclear whether the European leaders will be able to solve the eurozone crisis. The economic and fiscal woes in Portugal, Ireland, Greece, Italy and Spain grow graver with every passing day and thus, the prospect of default remains a real possibility," says the CME.

- Euromoney Skew Blog

CME: S&P downgrades were a "non-event" for many

The Chicago Mercantile Exchange says the range of country and EFSF downgrades were actually "non-events" - due to the markets already pricing in these moves in anticipation of a credit rating slash.

Topics

More in this section