By Greg Peel
Over 2010 and into 2011, global financial markets would react swiftly and sharply on news one of the major credit ratings agency had downgraded the sovereign debt of one of the eurozone basket cases by one or more notches. In short, risk-off would be applied in a big way.
However by late in 2011, markets began to realise that reacting to downgrades from Standard & Poor's, Moody's or Fitch was akin to hurling a beer can at the TV when your team loses the grand final again on the replay. Financial markets, and particularly debt markets, adjust to information almost instantaneously. Ratings agencies analyse, assess, ponder and agonise over their ratings "notches" for long periods. By the time ratings agencies have downgraded, markets have already long ago marked down the price of that debt.
Indeed in many cases a negative feedback loop occurs, in which ratings agencies downgrade because the market has already downgraded, thus having increased borrowing costs to the sovereign in question. By 2011 global markets began to realise that to sell again was to sell twice for the same reason, and hence downgrades began to be noted but not reacted upon. Outside of the euro-mess, the US rating was downgraded last year and a sharp response followed, for about five minutes. It was quickly appreciated that if you sell the bonds of the reserve currency there's basically nowhere else to put that money.
In August, Moody's announced it was reassessing its rating on Spain, which is one notch above "junk", or non-investment grade (IG) status. In September, Moody's announced it needed more time and would make an announcement in October. We're already half way through October and there hasn't been a peep out of Moody's, but in the interim S&P has sprung into action and downgraded its own rating on Spain by two notches to BBB- from BBB+, with a "negative" outlook.
This brings S&P into line with Moody's, such that for each another downgrade implies non-IG status.
As per recent times, the market didn't blink on the S&P announcement. Citi analysts are not surprised given the reasons S&P provided are hardly new news:
"The negative outlook on the long-term rating reflects our view of the significant risks to Spain's economic growth and budgetary performance, and the lack of a clear direction in euro-zone policy," and "The deepening economic recession is limiting the Spanish government's policy options."
If Moody's decides this month, finally, to downgrade Spain to junk, then it is likely the market may again not bat an eyelid. However as Citi points out, there can nevertheless be serious implications. Sure ? we all know it's junk anyway, and don't need Moody's or S&P to tell us. But the risk comes down to fund management policy. For example, Citi's own World Government Bond Index (WGBI) is made up of allocations only to bonds which are afforded an IG rating from either S&P or Moody's, and that index is used as a benchmark by large index trackers.
Other funds take S&P ratings as the only guide, others the best two out of three between all three agencies, and so on. The point is, however, that if Moody's does downgrade Spain to junk this month then Spain is only one S&P notch away from being declared non-IG by pretty much all global sovereign bond funds that invest only in IG bonds. And S&P has a "negative" watch.
Such an alignment would mean IG bond funds would have no choice but to sell Spanish bonds in their portfolios. Citi notes approximately US$1.5-2.0trn is invested in the WGBI of which 2.5%, or US$45-65bn is allocated to Spain. In theory, Spanish bond yields would fly to the moon.
As Citi rightly points out, markets are unlikely to wait to see what S&P ultimately does if Moody's moves to junk, and will no doubt start selling Spain and buying whatever bonds will be reallocated Spain's portion in the WGBI, which presumably is all of them. But having said that, we once again confront the Spanish Catch-22 issue.
Spanish bond yields are currently sitting comfortably under 6% (ten-year) because the ECB will start buying bonds if those yields rise and Spain has to ask for a bail-out. Bond vigilantes aren't game to take on the ECB. But while yields have remained lower, Madrid has decided, to date, it doesn't need a bail-out. Hence a stalemate.
If Moody's downgrades and markets were to respond ahead of an S&P downgrade, Spanish bond yields will rise and force Spain into a bail-out. But then the ECB would buy the bonds, meaning yields are unlikely to rise. Indeed, it is pretty much assumed Spain is already preparing for a bail-out but is just waiting for Germany to give it the okay, which is expected in November.
So maybe nothing will happen at all, other than markets in general being relieved and risk-on impetus returning. So in fact, Spanish junk might be a good thing. Citi is worried, nevertheless, in the meantime that that US$45-65bn must hit the market either way. Will the ECB absorb it all?
Perhaps that's the warning here.
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