S&P cut piles pressure on policy makers, underscores bank worries
By William L. Watts, MarketWatch
FRANKFURT (MarketWatch) — Italian government bond yields jumped Tuesday after Standard & Poor’s Ratings Services cut Italy’s credit rating one notch, dealing a blow to an increasingly fragile euro zone as policy makers struggle to contain Europe’s debt crisis.
S&P late Monday night cut Italy’s long-term credit rating to A from A-plus, and cut its short-term rating to A-1 from A-1-plus, citing a weak economic outlook and ongoing political gridlock. S&P said the outlook for Italy’s ratings is negative, meaning a further cut is possible.
The move by S&P took markets somewhat by surprise. All eyes had been on rival ratings firm Moody’s Investors Service, which had announced last week it would take an additional month to decide whether to downgrade Italy’s ratings.
“Just when everyone was waiting for Moody’s to downgrade Italy, S&P gets in first with what is a much more damaging downgrade as its rating of Italy was already the lowest of the three agencies,” said Gary Jenkins, head of fixed income at Evolution Securities in London.
The yield on 10-year Italian government bonds IT:10YR_ITA +1.51% rose 11 basis points to 5.62%, according to FactSet Research. The premium demanded by investors to hold Italian 10-year bonds over German bunds DE:10YR_GER -1.84% widened by around 13 basis points to 3.84 percentage points.
Rising borrowing costs highlight worries that the region’s sovereign debt crisis could engulf Italy, outstripping the euro zone’s rescue resources and throwing the future of the euro into doubt. Italy’s economy is the third-largest in the euro zone and its bond market is the third-largest in the world.
The European Central Bank began buying Italian and Spanish bonds in early August, pulling Italy’s yield down from more than 6% to less than 5%. But yields have crept back up in recent weeks.
The cost of insuring Italian sovereign debt against default using instruments known as credit default swaps, or CDS, jumped on Tuesday. The spread on five-year Italian CDS widened to 515 basis points from 493 on Monday, according to data provider Markit. That means it would now cost $515,000 annually to insure $10 million of Italian debt against default, a rise of $27,000.
Worries about the banks
The downgrade highlights worries about Europe’s banking sector, particularly French banks.
Fears over the potential impact of a Greek default on highly-exposed French banks and the rest of the region’s banking sector prompted the European Central Bank and other major central banks last week to pledge to provide increased dollar liquidity amid signs banks are becoming increasingly reluctant to lend to each other.
“The worsening outlook for Italian sovereign debt is clearly most problematic for domestic banks, although, outside of Italy, it is likely to be the French banks that once again come under scrutiny as a result,” said Michael Symonds, credit analyst at Daiwa Capital Markets in London.
Data from the Bank for International Settlements released over the weekend showed French banks had the largest exposure by country to the Italian public sector at $105 billion, followed by Germany with $51 billion.
Italian equities were volatile, with the FTSE MIB index up 0.4% in midday trading, rebounding from earlier losses.
The euro EURUSD -0.11% dropped versus the dollar in the wake of the downgrade and remained lower at $1.3655 in recent action, down from around $1.3685 in North American trade late Monday. Read Europe Stocks.
The downgrade could increase Italy’s borrowing costs just as the country embarks on a large refinancing program that entails nearly 30 billion euros ($41.3 billion) of gross bond issuance in October and November, said Boris Schlossberg, director of currency research at GFT.
“These upcoming bond auctions could become the true test of the country’s credit strength and, if investors balk at rolling over its debt, the downward pressure on the euro could quickly accelerate,” he said.
The cut leaves S&P’s long-term rating on Italy three notches below Moody’s Aa2 rating and two notches below Fitch’s AA-minus, noted Evolution’s Jenkins.
“The S&P move is likely to be very negative for sentiment because whilst the market was expecting a downgrade, it was probably not expecting one from an agency with the lowest rating which did not even have the sovereign on credit watch, but merely a negative outlook,” he said.
S&P said the downgrade reflects its view that Italy’s weakening economic growth prospects and “fragile governing coalition and policy differences within parliament will likely continue to limit the government’s ability to respond decisively to the challenging domestic and external macroeconomic environment.”
Italy’s parliament last week responded to growing pressure to cut its deficit by approving a nearly €60 billion austerity plan. Approval came after Italian Prime Minister Silvio Berlusconi’s government initially backtracked on a range of revenue-raising measures.
S&P said it was unconvinced the measures would work, partly due to concerns that additional austerity measures themselves will further weaken Italy’s growth outlook.
“We believe the reduced pace of Italy’s economic activity to date will make the government’s revised fiscal targets difficult to achieve,” the ratings firm said in a statement. “Furthermore, what we view as the Italian government’s tentative policy response to recent market pressures suggests continuing future political uncertainty about the means of addressing Italy’s economic challenges.”
William L. Watts is a reporter for MarketWatch in Frankfurt.
