How Will the EFSF Downgrades Affect the Pound

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How Will the EFSF Downgrades Affect the Pound?

The euro remained steady in thin trading during the North American session where US markets were closed for the Martin Luther King public holiday this Monday.

Standard & Poor’s announced late in the session its decision to downgrade the European Financial Stability Facility (EFSF), which is the European bailout fund. Just days after downgrading France and Austria from their coveted triple A credit status, the EFSF has had its own AAA rating cut by one notch to AA+.

The euro was stable after the news just after 18:00 GMT. EURUSD had slipped slightly before the announcement on speculation of a downgrade but then pared losses. EURUSD has been mostly range bound since the European open today, trading between 1.2638 – 1.2686.

In a statement, the EFSF said the downgrade would not affect its lending capacity, and emphasised that its short-term rating remained at S&P’s top level.

EFSF director Klaus Regling said after the downgrade news that the EFSF will retain its effective lending capacity of 440 billion euros despite Standard & Poor’s decision to downgrade its long-term rating by one notch to AA+.

In other currencies, GBPUSD rose to a day high of 1.5350 from the Asian session open of 1.5277. USDJPY fell to 76.69 from 77.04. USDCHF was range-bound above 0.9523 while EURCHF moved off four-month lows to climb to 1.2097 on the day.

The Canadian dollar was the biggest gainer as it edged higher against its U.S. counterpart on Monday, supported by stronger oil prices, but investors remained cautious in the aftermath of rating downgrades on several euro zone countries. Rising oil prices helped keep the Canadian dollar elevated since oil is Canada’s major export. Iran said today that a disruption to crude supplies through the Strait of Hormuz would cause a shock to markets that “no country” could manage”. USDCAD fell to a low of 1.0163 from the day high of 1.0251. The loonie hit a twelve-month high against the euro, as EURCAD tumbled to 1.2879 today.

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Crisis in the Eurozone: The Reality of the European Downgrades

By Jack Barnes , Global Macro Trends Specialist , Money Morning • January 20, 2020

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It turned out to be a ruinous Friday the 13th for Europe last week.

That included dropping Austria and France to AA+ status from their formerly lofty AAA rating.

While the decision was expected, and will most likely be followed by additional downgrades from the other rating agencies such as Moody’s Corp. (NYSE: MCO) and Fitch Ratings Inc., it’s the knock-on effects that will have larger implications for investors around the world.

In the Wake of the European Downgrades

The first and most obvious effect was the downgrade of the European Financial Stability Facility (EFSF) that followed on Monday. In the wake of Friday’s bad news, the EFSF was also dropped to a AA+ rating.

According to the S&P:

“We consider that credit enhancements that would offset what we view as the now-reduced creditworthiness of the EFSF’s guarantors and securities backing the EFSF’s issues are currently not in place. We have therefore lowered to ‘AA+’ the issuer credit rating of the EFSF, as well as the issue ratings on its long-term debt securities.”

The S&P also warned more EFSF downgrades would follow if the ratings of other individual states dropped in the future.

In a warning the EFSF could fall below AA+ the S&P said:

“Conversely, if we were to conclude that sufficient offsetting credit enhancements are, in our opinion, not likely to be forthcoming, we would likely change the outlook to negative to mirror the negative outlooks of France and Austria. Under those circumstances we would expect to lower the ratings on the EFSF if we lowered the long-term sovereign credit ratings on the EFSF’s ‘AAA’ or ‘AA+’ rated members to below ‘AA+’.”

So where do we go from here?

Why the EFSF Downgrade Looms Large

It’s my expectation that the downgrade of the EFSF will have a larger overall impact than the individual ratings downgrades that occurred on Friday the 13th.

The EFSF was supposed to provide $440 billion in emergency funding to states in need of liquidity but were unable to access the capital markets at prices they could pay.

While no one was willing to publicly call the EFSF a bad bank, because it wasn’t issued a banking charter, it was set up as a special investment vehicle (SIV) to handle the arbitrage between AAA bonds in Europe and A-like rates demanded by market participants.

In simple terms, the EFSF was expected to be able to issue cheap debt, which it would use to buy up sovereign debt at fixed rates below what the individual states could get on their own.

The problem is the downgrade will increase the cost of issuing debt at the EFSF, which will mean that its main reason for existing will be nullified by the market. In other words, the debt it issues will be less cheap.

As a non-sovereign, non-bank investment vehicle with less than a AAA rating, I believe the EFSF will find a serious lack of interest in its issuing debt.

In fact, the lack of demand for its debt – even with a AAA rating – was already a joke among market professionals.

Now with a lack of AAA support left in Europe to cover its guarantee commitments, I don’t believe the EFSF will ever play a major role in stabilizing Europe.

Europe’s Only Real Life Line

The S&P said in its announcement that it would consider upgrading the EFSF to AAA again if the national commitments were increased.

However, this upgrade path back to AAA was quickly damaged by Wolfgang Schaeuble, the finance minister of Germany, who made it very clear Germany did not plan on adding to its EFSF commitments.

“It is sufficient,” Schaeuble told Deutschland Radio. “The guarantee sum that we have is sufficient by far for what the EFSF has to do in coming months.”

That means Europe’s only real lifeline now is the International Monetary Fund (IMF), which will supersize the capital base and bail out the whole continent when the needed bank recapitalizations happen.

While the EFSF downgrade has garnered a lot of near-term economic focus, the reality now is that Europe needs to work on its Union structure if it plans on regaining a path towards organic growth.

News and Related Story Links:

    Standard & Poor’s:

Hedge Fund Manager Bets On Coming Downgrades For France And Germany

The hedge fund, which manages $24.5 billion in assets cited potentially high costs of bailing out periphery countries throughout the European Financial Stability Fund and France’s huge exposure to Italy as reasons for a possible downgrade.

Graham Neilson, the fund’s chief investment strategist told Reuters, “France is likely to be downgraded either on its own metrics but more likely as a result of potentially higher EFSF costs. The bigger the EFSF, the more France is liable (and) the worse France’s credit rating the more it could be liable.”

A larger EFSF will also affect Germany’s rating.

“Germany could also quite easily be downgraded if the EFSF is forced to be larger, in a scenario where France and Germany end up with debt to GDP ratios of 120-125 percent. That’s not good, that’s not AAA,” Neilson added.

But this week, Angela Merkel and Nicolas Sarkozy failed to come to an agreement that would increase the size of the EFSF.

Standard and Poor’s recent downgrade of the United States did nothing to increase the Treasury’s borrowing costs, and therefore it is not certain that a downgrade would affect bond yields for France and Germany. The downgrade of the United States was seen by some analysts as an attempt on the part of S&P to regain it’s legitimacy after their colossal failure to accurately rate reams of mortgage-backed CDOs prior to the financial crisis of 2008.

Downgrades are often good predictors of actual defaults, but the markets are usually ahead of the ratings agencies.

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