The Reality Of Moody's European AAA Downgrades
The importance of the negative credit outlook from Moody’s lies less in the realm of financial markets, given how little investors seem to value the views of the credit rating agencies. Rather the major importance lies in the policy and political reactions to the rating actions. As UBS notes, there is a risk of popular (not political leadership) adverse reaction. The media in Germany (where there is a tradition of media hostility to the Euro periphery) or in the Netherlands (approaching a general election in September) may portray this as "we are being dragged down by the Euro periphery". If that does transpire it could easily fan the flames of populist resentment of the Euro still further. Critically, if the media attribute (or mis-attribute) the blame to the periphery, there could be obstacles to that integrationist momentum. The reality of a common monetary policy and the necessity of some kind of communalized fiscal responsibility are being brought to bear on the Euro area polity - but markets seem confused. CDS markets are pricing Germany's risk as if it was becoming increasingly encumbered to the periphery and yet the FX market is dragging EURUSD lower on expectations of massive upheaval and potential SPexit with no German 'unlimited' support. CDS appears to fit with raters, FX more with haters.
The spread between Germany and USA 'risk' has risen notably since the EU Summit. This implicitly means the market is pricing in some level of acquiescence by Germany. At the same time, EURUSD has slipped dramatically lower as it appears that market believes that the EU is heading to some cataclysm reality (that implicitly does not include an unlimited German backstop).
While the CDS move fits with the ratings agencies (Germany's risk is higher as it will implicitly weaken its balance sheet by being encumbered by the periphery); FX markets appear to reflect a different - worse - scenario.
We do note that the last few days, German risk has compressed modestly - as perhaps all the hope from the EU Summit that perhaps Germany was indeed moving towards the less-sovereign-transfer 'integrationist' perspective is now fading fast. It seems to us that either Germany is a safer 'risk' as it remains ensconced on its fence-sitting that nothing has changed and/or FX markets misjudge the German's acquiescence.
However, for all those who believe Germany is the savior uber alles - UBS notes that thinsg might not be all they appear - and a downgrade makes perfect sense (with or without integration):
Although the move towards a downgrade for the Euro area sovereigns is rooted in collective responsibility, it is worth pointing out that there is an element of national responsibility as well. Finland is not being put on negative outlook despite being a part of the same collective entity. The reason for this is the Finnish balance sheet (principally) and the low net debt position. In contrast economies like Germany have seen a significant increase in its government debt burden over the course of the past few years - in large part because of the shockingly weak nominal growth performance of the German economy over the course of this century. Germany has demonstrably failed to grow its way out of debt, which means its net debt position is not strong enough to maintain a stable credit outlook in the face of the vicissitudes of collective responsibility.
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