Bursting the Eurozone’s AAA rated bubble

WITH the long-term health of the AAA-ratings of the core Eurozone countries looking shaky at best, is it going to be a case of last man standing for Europe? And will the credit ratings agencies end up deciding the direction of the haven currency flows?

Sarkozy has been telling anyone who will listen that, should France lose its AAA rating, then it is not the end of the world. In an interview with French newspaper Le Monde, he said that the ratings agencies had identified French banks as a risk to France’s rating, but the European Banking Authority had deemed them to need less capital than their German counterparts. While it is admirable that the French premier has an almost child-like optimism and faith in the results of the European Banking Authority – a trait often so lacking in the cynical world of finance – he forgets that this is the same authority that gave Dexia a clean bill of health.

But, beyond the ratings agencies, did the bond markets actually strip France of its AAA rating months ago? With a five-year CDS on its debts trading at 228.75 basis points, it is difficult to justify France’s continued membership of the AAA-rated tree house. Yet even to compare France to Germany seems like an ugly dog contest – many seem to still labour under the misapprehension that Germany is able to take care of Europe’s banking woes. With a number of its banks holding eye-watering levels of peripheral debt as a ratio of its common equity, as well as having the highest gearing ratios in Europe, Germany has more than enough problems of its own to take care of. The chart below, left, shows European banks’ recourse to the ECB’s deposit facility and acts as a useful indicator of inter-bank mistrust and liquidity stress – a fear that the counterparty to an inter-bank lending transaction won’t necessarily be around in three months. The banks instead deposit cash with the ECB’s deposit facility – monthly peaks coincide with the end of ECB reserve maintenance periods.

The remaining AAA-rated countries are Austria, Australia, Canada, Denmark, Finland, France, Germany, Holland, Luxemberg, Norway, Singapore, Sweden, Switzerland and the UK. Break them down into currencies and you have the euro, Canadian dollar, Singaporean dollar, Swedish krona, Norwegian krone, Swiss franc and sterling.

So to what degree will the ratings agencies affect these currencies? “Unexpected twists and turns for sovereign ratings can impact the currency to the extent that the currency reflects a risk premium,” says Stephen Gallo, head of research for Schneider FX. A high premium reflects a weak currency, and a low premium a strong currency. “At the moment, euro is already being priced for a ‘phase out’ of the remaining AAA-rated sovereigns within the bloc.” He adds: “German yields will also have to rise so that the increased risk premium is split between the value of the euro and the government’s cost of borrowing.”

In times of crisis, the Swiss franc would usually be the haven currency of choice, but the Swiss National Bank moved to place a floor under the euro-Swiss franc pair at SFr1.20, with the goal of deterring the huge capital inflows that were overheating the franc and damaging the country’s exporting economy. There have been fears that, when the SNB meets tomorrow, the central bank could raise the floor to SFr1.25. But Eurozone macro news has made this unlikely, with many shying from assets with strong links to the Eurozone problem.

Due to their strong ties to US and Chinese macro conditions respectively, the Canadian dollar and Aussie dollar tend to weaken in a downturn. Not suffering from the Icelandic disease of huge foreign currency denominated debt exposure, Sweden and Norway may end up being the last ones standing. So will this cause them to become haven attractions? “In a word, yes,” says Gallo. “I expect Nordic strength versus the euro in early 2011, and I also think that despite slower growth these currencies may surprise on the upside, as both the dollar, and euro to a degree, remain impaired and less desirable as reserve currencies. After all, the capital needs to flow somewhere.”

These currencies do, of course, carry the risk of Switzerland’s fate of a rapidly overheating currency. But in the case of a mass downgrade of European financials, traders should look to Nordic shores for AAA-rated gains.