4 Reasons Why the Effect of S&P’s Downgrades Will Be Muted

‘Twas Friday the 13th when one of the euro’s worst nightmares came true. Renowned credit rating agency, Standard & Poor’s (S&P), went on a frenzy and downgraded the debt ratings of nine European countries. Both France and Austria lost their prized AAA grades while Italy and Spain saw their ratings drop two notches. Portugal was hit hard when it received junk status for its debt. Malta, Cyprus, Slovakia, and Slovenia also got their bonds downgraded as well.

Consequently, the euro tumbled on the charts. EUR/USD dropped 256 pips from its intraday high of 1.2880 to its 16-month low at 1.2624 following the announcement.

EUR/USD 15-minute Chart

With the big news and the strong downward move on the euro, I’m sure many of you are thinking about shorting the currency. However, I wouldn’t be so sure about that yet if I were you. Analysts are saying that you may have already missed the boat.

If you remember, in August 2010, the credit rating agency made the bold move of stripping the U.S. of its pristine AAA rating. Although it shook U.S. stocks a little bit, it did not have a lasting effect on the markets. Some economic gurus are saying we will likely see a repeat of the muted reaction from markets following the S&P’s euro zone downgrades. Here are four reasons why:

1. SURPRISE! Not.

S&P’s decision wasn’t much of a surprise and investors had enough time to brace themselves. In December, the credit rating agency put 15 European countries on downgrade watch which included the biggest economies in the region, Germany and France. And so, the month-long warning should keep markets from panicking and driving borrowing costs higher than they already are.

2. It could’ve been much worse.

Besides, several economic hotshots say that the downgrades could’ve been much worse. For one thing, word through the grapevine before the downgrades were actually dealt was that France’s triple-A rating might get knocked down by a couple of notches to AA. After all, France’s budget deficit reached 7.1% of its GDP last year, which is unbecoming of a triple A-rated government debt and is more than twice the 3% limit for euro zone nations.

With that, the downgrade of French debt to AA+ turned out to be somewhat of a relief for some market participants. Add to that the fact that Germany, euro zone‘s largest economy, was spared from any downgrades completely. Phew!

3. S&P’s perfect timing.

Another factor that could limit the markets’ reaction was S&P’s decision to make their announcement after the New York session closed, just when European traders were trying to get a good night’s sleep. Bear in mind that the downgrades were doled out right before U.S. traders went off on a long weekend, which meant that they have plenty of time to digest the news before the next week of trading.

4. Spain and Italy had relatively successful bond auctions.

Last but certainly not least, another reason for the markets’ muted reaction would be that Italy and Spain were already done with their bond auctions before S&P downgraded their sovereign debt. In fact, Spain’s bond auction the previous day actually turned out to be a success as they sold roughly 10 million EUR worth of bonds, twice as much as they expected. Similarly, Italy’s bond auction on Friday morning also turned out better than expected as demand for their bonds remained strong and bond yields falling by nearly 15% from their previous sale.

Imagine how things could’ve been way worse if those bond auctions churned out weaker than expected results, only to be followed by a downgrade-fest by S&P!

Then again, this is only my humble opinion. Just because the euro zone situation is currently better than expected doesn’t mean you should get excited about buying the euro. You know what they say, if you expect the worst, everything does seem better than expected!

Don’t forget that the ongoing euro zone debt crisis is now more than two years old and isn’t expected to end anytime soon. As S&P pointed out in its recent statement, no real progress has been made when it comes to resolving the fiscal problems in the region and that a default might be in the cards for some nations. With that, a double-dip recession is still a looming possibility and this could have a nasty ripple effect across the world.