So Greece received its bailout…yawn….the markets knew this would happen. In fact, those market participants who read The Divergent View, were alerted to this fait accompli weeks ago. As anticipated, the EURUSD [exchange rate] did not rally on the news…We expect the EURUSD to drop to at least 1.29.
As an interesting sidebar to the weekend deal, the ECB dropped its ratings threshold for Greek debt – this is important because a ratings cut from Moody’s could have shut Greek banks access to ECB funding.
The Consensus View – Greece Bailout Puts the European Fire Out
Prior to the weekend deal, the prevailing market view/hope was that a bailout for Greece would stop the contagion threat and provide Europe with some economic breathing room. At the core of this view is the assumption that the markets will applaud coordinated action and extrapolate this approval to other European nations.Moreover, the indefinite extension of lowered ECB ratings threshold is expected to keep the liquidity flowing.
Not surprisingly, we do not share this view.
The Divergent View – The Threshold Extension Paves the Way for a Downgrade
Before we get to the core of the matter, a primer:
The ECB loans out money to member state banks and takes government bond holdings as collateral. Prior to the financial crisis, those government bonds needed to be A rated by at least one of the three ratings agencies (Fitch, S&P, and Moody’s). As part of the response to the financial crisis, the ECB dropped the ratings requirement – this change was expected to expire at the end of 2010.
The Core
Both Fitch and S&P have already cut Greek debt ratings below ‘A’, leaving Moody’s with the all powerful vote at the tribal council. Last week, Moody’s suggested it would not cut the ratings until it reviewed any bailout that may come over the weekend – a cut prior to an approved bailout could have proved catastrophic. Presumably someone at Moody’s was working over the weekend.
The ECB decision to indefinitely suspend the ratings threshold means that Moody’s is now free to speak its mind and downgrade Greece without the reputational risk of being labeled the Euro killer. We expect this new found freedom will result in a Moody’s downgrade of Greek debt and could lead to further European downgrades.
While Moody’s et al now have the freedom to actually rate sovereign debt without the threat of being a world destroyer, we do not believe the markets are expecting more ratings news. In the long term, ratings downgrades would more accurately reflect the true risk associated with holding European sovereign debt – however – we believe the knee jerk reaction in the market will be a sharply lower EURUSD.
Disclosures: Short EURUSD and FXE puts
