LONDON (Reuters) - A mass ratings downgrade of euro zone countries expected early this year is likely to increase selling pressure on French and Italian government debt, but could paradoxically consolidate Germany’s safe-haven status.
Standard & Poor’s has warned it could soon downgrade the triple-A ratings of Germany, Austria, the Netherlands, Finland, Belgium and Luxembourg by one notch and the ratings of other euro zone countries, including top-rated France but excluding Greece and Cyprus, by two notches.
If they materialize, and analysts say they are largely priced in, the downgrades would reinforce fears the currency union could collapse under the weight of member states’ debt. This could inflict severe damage on even the bloc’s financial powerhouse and perceived least risky country - Germany.
Its sovereign rating would fall below those of Australia, Canada or Sweden. But those countries’ debt markets are much smaller than Germany’s and will remain overlooked by investors seeking the safest bonds available.
A more liquid market is considered safer as investors can close an underperforming trading position more easily and limit their losses. At around 2 trillion euros, Germany’s gross debt is about 14 times that of Sweden in nominal terms.
Any German rating cut would rattle another pillar of the investment world after U.S. debt was downgraded in August.
“If (investors) are only mandated to invest in euros, then they’ve got nowhere to go. If they’re allowed to invest in euros and U.S. dollars, well the amount of triple-A paper would still be zero,” said Lyn Graham-Taylor, rate strategist at Rabobank.
“(The UK) is quite a small market and kiwi, Aussie (the New Zealand and Australian dollars) are also quite small so you wouldn’t expect a huge reallocation simply because there isn’t a large triple-A market left out there.”
In face, Graham-Taylor said, German debt could outperform as it would benefit from outflows from elsewhere in the euro zone if France or other states suffered deeper rating cuts.
The downgrades would almost certainly lead to a rating cut for the euro zone’s EFSF bailout fund, which would hamper hopes it could become a credible institution, along with the European Central Bank, to help Italy and Spain.
The duo, as well as France, which is heavily exposed to them, could then be seen as more vulnerable.
“We possibly could see a bigger impact on peripheral spreads given that the market may question the viability of the EFSF mechanism,” said Michael Leister, rate strategist at DZ Bank.
Investors are already bracing themselves for a world of lower-rated governments. French 10-year bonds yield 140 basis points more than German Bunds, compared with 40 bps six months ago and part of the widening was fuelled by expectations France will lose its triple-A status.
Graphic of tripla-A euro zone govt bond spreads
Despite the downgrades being widely anticipated, analysts say the spread widening trend in France and elsewhere has further to go in the absence of a solution to the debt crisis.
“Already quite a few investors in our client base have reduced exposure to a country like France. We already have a cautious stance on France ... It would not have an impact on our positioning,” said Kommer von Trigt, a bond fund manager with Robeco Group, which manages about 140 billion euros.
But while it would not affect Robeco’s funds, which are allowed do invest in any country, some of the group’s clients may be forced to cancel their exposure to French debt because their investment rules mean they may only invest in triple-A debt, he added.
“It’s very clear at least to us that French yields will continue to trade much higher versus Germany than two years ago,” von Trigt said.
If Germany is downgraded as well, the triple-A benchmark will lose its significance, he said.
Graphic by Vincent Flasseur, additional reporting by William James, editing by Nigel Stephenson