S&P Cuts Spain's Rating Two Notches to BBB+

Currency in Crisis

S&P cut Spain's sovereign rating by two notches to BBB+ after the NY markets closed. Although Spanish bonds have under-performed this year, with the 10-year yield rising 80 bp, despite the two LTROs and seemingly better appetite for risk, the two notch move caught the short-term market wrong-footed. In thin pre-Asian markets, the dollar, yen and US Treasuries traded higher, while equities retreated.

Not only did S&P deliver the two notch downgrade, but retained a negative outlook and warned of significant risks to both growth and fiscal policy. It signaled the conditions under which it would cut the rating again: if the debt/GDP ratio rose above 80% or if political support for reforms waned. Ironically, many private rather than official estimates put Spanish debt at or above 80% presently.

S&P last cut Spain's sovereign rating by two notches at the start of the year. It said that it now expects the budget deficit to worsen more than it previously projected. S&P also indicated it expects the government to do more to support the banking sector, which underscores the dangerous public-private sector linkages and why some in Europe want banks to have direct access to ESM funds. Moody's rates Spain a notch higher now than S&P at A3, whereas Fitch rates Spain 2 notches above S&P at A. All the rating agencies have negative outlooks.

Next Thursday, Spain will seek to sell 3 and 5 year bonds. The downgrade and the likelihood that the PMI shows further deterioration of the Spanish economy, which in the current environment means deficit/GDP slippage, as the denominator falls faster than blood can be squeezed from the turnip (austerity), make a less than conducive environment for Spain to go to the market.

Tactically, it may appear Spain has some breathing room as it has covered half of this year's financing needs. However appearances may be deceiving. It market conditions push it to the sidelines, the bears would be emboldened further. Moreover, by various market calculations, Spanish banks, the key buyers of Spanish bonds this year, are running out of capacity to continue.

The ECB has been reluctant to resume its sovereign bond purchases, but pressures are building. The situation in Europe looks particularly fragile a week before the decisive round of the French presidential election and the Greek national election. Now does not appear to be a particularly good time for the firemen to teach people a lesson for playing with matches.

As the April 30 EC deadline approached, the Dutch government appears to have cobbled together sufficient support in parliament for additional savings measures.  Although Dutch bonds outperformed in reaction, as the market assumes it means less risk of a downgrade in creditworthiness or outlook, the positive news is unlikely to be sufficient to offset anxiety that will be spurred by the S&P downgrade of Spain.