Markets normally would be looking for an orderly winding down process to the Christmas and New Year period amid hopes for a tentative improvement in risk appetite on year-end position adjustment. Any sense of relaxation this year is likely to be undermined by constant uncertainty surrounding the threat of further credit-ratings downgrades amid unease surrounding the eurozone outlook.
Moody’s warned over the French rating on Friday as it was placed on negative watch along with 6 other eurozone members. Markets will remain on high alert over the risk of a downgrade of French ratings by Standard & Poor’s.
A key problem of course is that there is no set timing for ratings announcements. Funds and traders alike can protect themselves from risk surrounding key economic data releases, but this option is much more difficult with the credit rating announcements as they are announced with no warning. This factor also increases the risk of rumour-mongering as major players look to trigger stop-losses. There has been a pattern in that most of the downgrades come towards the European close and tensions will inevitably be high during this time of the day until any verdict is delivered.
France has attempted to take the sting out of any downgrade by talking down the implications. There is, however, still a clear sense of vulnerability, especially given the attack on the UK AAA rating by French officials. The political use of the UK during and after the EU Summit and the very surprising decision of Bank of France Governor Noyer to call for a UK downgrade certainly indicates that the French are rattled. As well as the economic impact which is serious enough, the political cost of Germany and the UK having a higher credit rating than France would be high and there would be another torrent of angry rhetoric from French officials in an attempt to discredit the ratings agencies.
French rhetoric and the long wait for an announcement will certainly lessen the impact of any downgrade as it has been partially priced in, especially if it is only one notch. A two-notch downgrade would be potentially much more damaging to prospects for French and eurozone stability.
Yield spreads will inevitably be watched very closely both within and outside the Euro area. There was a sharp fall in peripheral yields over the second half of last week as ECB actions took effect. The central bank collateral and liquidity arrangements have made it easier for eurozone banks to buy bonds and then effectively lend them to the ECB which both helps calm market tensions and lower yields at the same time as bolstering bank earnings.
The data releases over the past month have increased speculation that the US is the best-placed major area to make headway given evidence of a deepening downturn in Europe and a sharp reduction in Asian confidence.
If this pattern continues, then yield spreads will favour the dollar at the expense of the Euro. There would also be a further breaking-down of the correlation between risk an the Euro with the Euro finding it more difficult to gain ground even if there is an improvement in risk appetite and an easing of Eur0-zone fears.
The US outlook is still highly uncertain at best, but it shows that the Fed has gained some rewards from its aggressive pro-cyclical policy enacted over the first half of 2011 as quantitative easing took effect. A solid set of data releases would reinforce a sense of confidence with a particular focus on durable goods orders on Friday and jobless claims on Thursday. The latest housing starts and permits data will also be watched closely on Tuesday.
Wednesday’s Bank of England MPC minutes will be important in assessing bank confidence and intentions as the UK looks ahead with great trepidation to 2012. There is the possibility that there was a split MPC vote at the December meeting, although it is more likely that there was unanimity at this time. Comments on the economy will be watched very closely as the bank tone will be very important. A very downbeat economic assessment would be an important negative factor for Sterling. In this context, the second GDP revision could also be potentially important on Thursday.
The UK will not be immune to ratings speculation as there is certainly a possibility of action to at least put the UK on negative watch which would definitely unsettle the UK currency.