Partner Center Find a Broker

Ay caramba! Just when everyone was gonna close shop at the end of yesterday’s New York session, ratings agency Standard & Poor’s came out of nowhere and downgraded Spanish debt!

To be honest, the only real surprise was the timing of Standard & Poor’s downgrading of Spanish debt. It was almost a foregone conclusion that the ratings agency would follow Moody’s, who implemented its own downgrade back in June. S&P’s rating now sits at BBB-, which is at the same level as Moody’s Baa3 rating.

Aside from the downgrade, S&P also maintained its negative outlook on the country, citing increasing tension between Spanish government officials and the high possibility of economic contraction. In its accompanying statement, S&P predicts that Spain will contract by 1.8% in 2012 and 1.4%, as both the public and private sectors scale back on their spending.

What does this mean for Spain?

Now that its debt rating stands just one level above speculative grade, Spain is now entering the danger zone. Take note that if it were to hit junk status, it would force many hedge funds, investment firms, and pensions plans to dump Spanish bonds, which would just lead to even higher yields as investors would demand higher rates for additional risks.

This may leave the country no choice but to request a bailout as rising yields would make it unsustainable to keep issuing bonds. The problem of course, is that the Spanish government has been adamant about not requesting a bailout as it even tried to impose its own terms and stipulations.

What can happen if Spanish bonds become junk?

With the recent downgrade, S&P’s credit rating for Spain now matches Moody’s, which also put Spanish bonds a hairline away from junk status. Note that Moody’s is set to conduct another review by the end of the month and that several market watchers are already speculating that we could see another downgrade.

Meanwhile, Egan-Jones, a smaller credit rating firm, has been way more aggressive with its downgrades as it already put Spanish bonds deeper into junk status back in September. Fitch, on the other hand, kept Spain’s rating a couple of levels above speculative grade during its review last June.

If any of the bigger credit rating agencies finally decide to dump Spanish bonds below investment grade, the euro zone’s fourth largest economy might be forced to request for a bailout even against its own terms. Let’s see if beggars can still be choosers by then!

What could all these mean for the euro?

Based on recent euro price action, it seems that the currency is reacting negatively whenever Spanish bond yields spike or when Spain refuses to do anything to solve its debt crisis. In this case, a decision by the Spanish government to give in to a bailout could be positive for the euro as it could be seen as a step forward in keeping the crisis contained.

Although the possibility of a Spanish bailout has been priced in for quite a while, things could get ugly again for the euro in the longer run if Spain turns out to be another Greece and ends up requesting more than just one bailout. Do you think this is likely to happen?