Moody's Joins Party, Slashes Spain's Rating

Currency in Crisis

Shortly after the US markets closed, Moody's announced it was slashing Spain's sovereign debt rating three notches to Baa3.  This is one step above junk status.  The euro, which had generally traded higher in North America, was softening going into the close.  The announcement pushed it down further, but it still managed to finish the day above its 20-day moving average (~$1.2540) for the first time since May 1.

Moody's had warned before the weekend that it could downgrade Spain and following Fitch's move, Moody's was the laggard.  On Monday, I warned that this was the immediate risk and I even repeated it on Bloomberg TV.  It was hardly surprising then and I think that the technical factors favor a continuation of the corrective-cum-consolidative phase.
  

This may also be encouraged by some connecting the weak jobs data on June 1, the soft retail sales and inventory data earlier today to reach QE3 next week.  That said, the Greek election outcome is the most important driver early next week ahead of the FOMC meeting, where the outcome is not known until mid-week.  

The most important immediate impact may not be prices as in the euro or even Spanish bond yields, but on the ECB's rules.  It sets the discount (haircut) on collateral based on the the highest of the main rating agencies--which seems kind of backward--in a risk situation why link to the laggard (small measure ECB takes to support the weaker paper and raises concern about the quality not just the quantity of its balance sheet).  

In any event, Moody's was the highest.  The rating cut will force Spanish collateral to be marked down another 5%.  This will force those who have used it (Spanish banks mostly) either pony up more or pay back some ECB loans.  This further squeezes the banks and underscores the deadliness of the linkage between the sovereign and the banks.  

Moody's cited a few reasons for its decision, which are worth looking at because it suggests what it will be looking at to resolve the negative outlook, which it said it will likely do within 3 months.  That said, if Greece drops out of the euro zone, this alone could push Spain into junk status.  

Moody's cited getting international assistance and its limited access to the financial markets.  It also cited the Greek PSI as precedent to make private creditors share the burden of adjustment. It warned that Spain's debt/GDP would likely rise through the middle of the decade and that it was moving toward a full aid package. 

As part of its explanation of why it still regarded Spain as investment grade it noted that the 100 bln euros financial assistance was 10% of Spain's GDP.  This was considerably smaller than Greece's 114% of GDP, Ireland's 54% and Portugal's 46%.  It also said it was less concerned about subordination in Spain as senior credits little more than 10% of Spain's public debt.  In Ireland and Portugal, in contrast, 37-40% of the public debt is accounted for by senior credits.