Downgrade of Italy adds to Eurozone woes

THE downgrade of Italy’s sovereign debt rating by Standard and Poor’s (S&P) ratings agency was another sounding of the death knell for the Eurozone in its current incarnation.

When it announced the revision yesterday from A+ to A, S&P noted Italy’s “weakening economic prospects” and the difficulty of the “fragile governing coalition” being able to respond decisively to the debt crisis.

Moody’s has also stated it would be reviewing Italy’s finances, although most expect them to follow S&P’s lead and downgrade Europe’s third biggest economy. The announcements sent Italy’s Credit Default Swap spread up to 494, which would price in a 29.9 per cent five-year cumulative probability of default. “It goes to show now that the credit ratings agencies are not just focusing on the economic fundamentals, but also on the ever increasing relationship that politics plays in economics,” says Chris Towner, director of FX advisory services at HiFX. The reasons given for the downgrade were very similar to those given when the US was downgraded earlier in the year: the country lost its AAA rating as a result of political deadlock rather than immediate fears that it would be unable to service its debts.

The news from Italy breaks with market focus on Greece’s woes. But while a Greek default could feasibly be soaked up by other Eurozone nations, Italy is a very different beast. With the third largest bond market in the world, there is nobody who could prop them up if they were to fall. And the markets know this all too well – euro-Swiss franc actually strengthened on the back of the news that Italy was downgraded. According to Angus Campbell, head of sales at Capital Spreads, Italy is likely to see further downgrades. Should this happen, Campbell points out that central banks see Italy as simply too big to be allowed to fail: “It has almost got to praying time for investors in the hope that the European Central Bank can keep Italy’s government bond yields sufficiently low for them to avoid such an event.”

With yesterday’s development, many will be speculating as to how long the Euro-Swiss franc floor – put in place by the Swiss National Bank (SNB) two weeks ago – will hold out. This was reinforced by big movements in Swiss franc pairs yesterday following market chatter that this morning would see the SNB redouble its efforts at combating a strong franc by raising the floor under the euro-Swiss franc to SFr1.25. This was denied by the SNB, which knocked the euro-Swiss franc and dollar-Swiss franc pairs off their intra day highs.

So where are the European currencies heading? “Even though the euro will trade lower against the dollar, I’m not certain that this will have a major impact on euros-Swiss franc in the short term,” says Alejandro Zambrano, market strategist at FXCM. “The Swiss franc is already trading lower against the dollar and I expect the same versus the euro. I predict the euro-Swiss franc will reach SFr1.30 as long as prices trade above SFr1.1.”