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Euro Tanks as Spain Gets Downgraded: What Does It Mean to Be Downgraded?

Mon, Jan 19 2009, 15:18 GMT
by Kathy Lien

GFT

With the US markets closed for Martin Luther King's Day, the odds were skewed towards a quiet trading. However, big news in Europe has made it anything BUT quiet.

After hitting an intraday high above 1.33, the EUR/USD has sold off aggressively on news that Standard and Poors downgraded the sovereign debt rating of Spain from AAA to AA+. The outlook is stable which means that further downgrades for the country is unlikely. However this could be the beginning of more downgrades in the Eurozone. Last week, Greece's sovereign debt rating was downgraded as well to A- while Ireland and Portugal have been placed on credit watch. The reasons for the downgrades are obvious. The Eurozone is in recession and those countries have suffered greatly. Also, public finances have deteriorated materially since the governments are trying to spur growth by spending.

What Does It Mean to Have Your Credit Rating Downgraded?

To have your credit rating downgraded means higher costs of borrowing. The Euro is slipping as we are seeing an exodus out of Spanish bonds because some global funds are mandated to invest only in AAA debt. A credit rating reflects the risk of default. Therefore a lower credit rating means that a country is at greater risk of defaulting on their debt. On a local level, we expect investors to shift their money out of Spanish debt and into countries with a higher credit rating such as Germany or even outside of the Eurozone. Spanish Bond prices have dropped significantly since the beginning of the year, driving yields higher. The gap between the interest rates on German and Spanish bonds have hit the highest level in 10 years, reflecting the sharp divergence in economic performance. Talk of Spain leaving the Eurozone is irrelevant because their cost of borrowing would skyrocket if they chose to do so. I think that there is a greater chance the countries being downgraded will be kicked out of the Eurozone.

British Pound Below 1.45 After New Announcements by UK Government

The British pound has also fallen below 1.45 after the UK Treasury announced more groundbreaking measures to stimulate the UK economy. They have set up a program to guarantee bad debts and buy up to GBP50 billion in private sector assets. They will also be increasing their stake in the Royal Bank of Scotland. This is aimed at pumping more money into the economy and may be a step towards quantitative easing. Although the UK government has been the most aggressive in coming up with measures to turn the economy around, the British pound has sold off because investors fear that the step was taken because the outlook for the UK economy was worst than feared. They are also doubtful that the government's efforts will pay off.

Published on  Mon, Jan 19 2009, 15:20 GMT