Knee-jerk reaction to downgrades, unlikely to last long
The downgrades for Eurozone governments by rating agency Standard & Poor's was widely foreseen. After an initial drop, the EUR/USD exchange rate is stabilizing. On the other hand, bond yields of the weaker EMU countries barely rose, and also stock indices were hardly affected. According to analysts, this is the result of a 'buy-the-rumor, sell the fact' mood. Moreover, the downgrades show that the battle against Eurozone debt burdens is ongoing, increasing the pressure on the ECB to open the liquidity taps. The combined effect for stocks and bond yields is neutral, but it is negative for the euro.
We believe the (indirect) consequences of the downgrades will prove larger than the initial reactions of the financial markets suggest, because the downgrades worsen the negative economic growth spiral and solvability problems (see also our Global Financial Markets reports). Firstly, because Chancellor Merkel presses for more fiscal austerity measures in an initial reaction to the downgrades. This hampers economic growth further, such that government debts weigh ever heavier, more fiscal consolidation is required to reduce debt burdens, etc.
Secondly, the downgrades endanger the lending capacity of the EFSF and ESM. These emergency funds were set up to provide Greece, Portugal and Ireland with temporary liquidity support. However, it is becoming increasingly clear that EMU countries are dealing with solvency problems, which begs the question how much money the stronger EMU countries are willing to pledge to the weaker countries, instead of solely how much they are willing to lend on a temporary basis. The downgrades make it increasingly unlikely that countries such as France and Austria - who have lost their cherished AAA-status - are willing and able to provide financial support to Greece et al, against the background of more fiscal austerity required at home - also due to the costs of their debt burdens rising, while their economies are flagging. Thereby, political support for such rescue operations (through the EFSF and ESM) is fading.
The private sector, on the other hand, is also unwilling to accept greater losses on Greek bonds. However, according to most economists 'voluntary' hair cuts on these bonds of 50% (but likely more) are necessary to bring Greece's government debt on a sustainable path. Without a deal with the private sector on write downs on Greek debt, Greece may be heading for default - with all the (chaotic) consequences that may entail.
Thirdly, the banks of the previously relatively strong EMU countries find themselves in an increasingly difficult position. As the credit rating of their respective governments is lowered, raising capital becomes increasingly difficult for these banks. In order to strengthen balance sheets, banks will thus have to turn to shrinking their lending portfolios (issuing fewer loans and not extending older loans) instead of issuing stocks and bonds. This hurts economic growth.
Consequently, we believe financial markets will start to assess the downgrades differently. We expect investors will increasingly come to realize that the S&P's downgrades will further limit the range of solutions to the euro crisis. A deeper recession and a more realistic danger of deflation will eventually force the ECB to start the printing press. We believe both will prove negative for EUR/USD over the coming quarters.