For most in the market, Moody's downgrade of Spain today is no great disaster because so few believed Madrid's forecast that it could restructure its banks for 23 billion euros. But traders say the now near-constant drumbeat of downgrades is only adding to anxiety, as we enter a very critical period for the euro zone.
Tomorrow (Friday) at 11am ET, the euro zone's 17 leaders will gather for an extraordinary summit in Brussels. By the end of the month, the market has been led to believe, they would agree to boost EU rescue funds and cut the costs at which the governments of PIIGS nations borrow.
But before Germany and France inject more taxpayer cash, they first want poorer nations to sign up to new mechanisms to discipline their future deficits.
When Berlin and Paris first presented their plan in February, the PIIGS pushed back. The fear is that there could be a major loss of market confidence if substantial progress is not unveiled at tomorrow's final news conferences, scheduled for 3pm ET.
"If there is no agreement there will be an unbelievably bad reaction," Simon Derrick at BNY Mellon tells me. "The underlying debt market is getting as stressed at it was in November — or at the height of the crisis last May. If there’s no resolution it will be horrible."
Today, the cost of insuring the debt of all five PIIGS nations' debt rose. It now costs $1,063 to insure $10 million of Greek debt. Derrick points out that Iceland's credit default swaps were only trading at $1,100 before Reykjavik closed its markets. Moreover, going in to the meeting, some euro zone leaders are openly talking of default.
The second-poorest nation at the table tomorrow will be Slovakia. Its prime minister, Iveta Radicova, told Reuters overnight that Greece and Ireland are paying too much on their international loans, and terms should be softened.
But Radicova added there is also a risk that Greece will default and euro zone rules should be changed to allow for that.
Since the German-French plan met with dissent one month ago, yields have been spiking higher on peripheral bond markets. That's led the ECB to repeatedly entering the market as a buyer, according to frequent reports.
Traders suggest that in Portugal's case, the bank may be attempting to draw a line in the sand that prevents the extra that the market demands to hold Lisbon's debt of benchmark German bunds breaking above 4.5%, the market's rule of thumb for a bailout having become inevitable. Tomorrow, Portugal's Prime Minister will also update the meeting on his austerity efforts.
No wonder this week the euro has continued to fall away from $1.40. But the Single Currency remains elevated as a result of this year's obsession amongst FX traders with dollar weakness — be it on QE2 quantitative easing arguments, or, more recently, higher oil prices.
Analysts like Derrick warn, however, that if the market were to suddenly re-focus on Europe's sovereign debt problems — at a time when oil prices might also be falling — the resulting fall in Euro/Dollar could be "quick and very dramatic."