Eurozone downgrades -- desperate, but not serious

The much-feared, yet equally much-anticipated, EU sovereign credit rating downgrades have arrived. The winners were Germany, the Netherlands, Finland, and Luxembourg, which saw their AAA ratings sustained. The losers were Belgium, Austria and France, which were cut one grade to AA+. The biggest losers were Italy, Spain and Portugal, which were cut two grades to BBB+, three steps above junk. The hope was that France could maintain its AAA rating, but a single notch downgrade was not entirely unexpected. Still, it does jeopardize the AAA rating of the EFSF and the successor ESM, but we will need to see the ratings agencies make that determination later. What we can expect next are ratings downgrades to the banks of the affected nations, which typically follows an adjustment to the sovereign rating.

While it’s still early to gauge the complete market fallout, what has impressed me so far is the relatively minor, calm reaction in key markets, suggesting that much of what has transpired was largely as expected, though perhaps a bit earlier than most thought. EUR/USD declined sharply (around 1.5%), but ultimately maintained the week’s 1.2650/1.2850 consolidation range. Italian, Spanish, and French government bond yields initially rose, but later fell back to finish with only minor increases; all are below their one month average yield, suggesting bond markets were expecting the downgrades.

Taken together, the market reaction so far suggests the potential for a rebound in EUR, especially in light of extreme short-positioning, on a potential ‘sell the rumor, buy the fact’ type reaction. Option markets pricing indicate bearish expectations now only slightly outweigh bullish views (1 month 25-delta risk reversals, an indicator of directional sentiment, have recovered to -0.375 from an extreme low of around -3.0 in early November when the EUR began its descent). Also, as the reality of the downgrades became more concrete on Friday, the weakness in EUR/USD only briefly exceeded lows made on rumors earlier in the week of an imminent downgrade, again suggesting that much of the news has been priced-in. To be sure, though, there is no reason we can’t see another leg down in EUR/USD. The weekly candlestick for EUR/USD looks to be forming an ‘inverted hammer,’ frequently cited as a bullish reversal pattern, but on its face is a bearish candle requiring confirmation in the following week. While the key 1.2600/10 level holds on a daily closing basis (76.4% retracement of the 1.1880-1.4940 advance), we think there is scope for a correction higher, at least. A daily close below there would suggest further weakness to the low 1.20’s, and likely below for a full 100% retracement. Above, the 1.2870/90 is the key resistance area where a move above would suggest potential to the 1.31/32 area in the short-term.

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