The ECB gets ready for war with the rating agencies

After yesterday’s quiet trading session caused by the US 4 July holiday, investors have come back in today and decided to keep away from risky assets. This may be a delayed reaction to yesterday’s news from rating agency Standard and Poor’s that the current plan being hashed out between Eurozone authorities and banks over a voluntary rollover of Greek bond holdings would constitute a default.

The European Central Bank (ECB) has reacted by saying that it will continue to except all Greek debt as collateral for loans until all rating agencies downgrade Greek debt, so far only S&P has come out and threatened Greece with a default. The ECB would rely instead on the best rating available. This is crucial for Greeks banks since they rely almost completely on the ECB to keep themselves alive, without this then the Greek financial sector would collapse, possibly causing contagion across the Eurozone.

The move by S&P has been met by a wave of criticism from EU officials. ECB member Nowotny made some noteworthy comments in a speech last night. He said that the ratings agencies were stricter on the Eurozone compared to South America and that the EU was having a difficult situation with the rating agencies. So is it war between the EU and the rating agencies? We will have to wait and see, but it appears that the EU feels hard-done-by and will do all it can to ensure that one rating agency’s downgrade for Greece won’t trigger a default event. Although rating agencies have had their credibility eroded since the sub-prime crisis, the EU taking matters into its own hands and questioning its treatment at the hands of the rating agencies also seems a bit rich.

Economic fears in Europe have risen in recent days concomitantly with sovereign concerns over Greece. Yesterday consumer confidence dipped to an 8-month low, today services sector PMI in the currency bloc fell to its lowest level since October 2010. Although the Irish survey rose to 52.4 from 50.5, the rest of the periphery is still struggling. There was also a worrying development for the core nations. Germany’s survey moderated and France saw a steep fall in sentiment in the service sector; its PMI fell to 54.9 from 60.3 last month.

The services sector has been hit by a downturn in domestic demand. Retail sales are also coming under pressure. Sales fell 1.1 per cent in May across the currency bloc; the annual rate is now 1.9 per cent lower than 12 months ago, back at rates last seen in December 2009.

This is likely to keep the pressure on European stock markets. However, we believe the euro may tread water until we hear more from [ECB president] Jean-Claude Trichet after the ECB rate decision on Thursday. The trajectory for interest rates has been clouded by  the downturn in growth, so for the euro to extend recent gains especially versus the dollar and the pound then we will need to see Trichet remain hawkish and upbeat that this is a mere blip for growth and not the start of something more serious.

Interestingly, the UK, where growth has been a major concern in recent months, saw a slight improvement in its services sector PMI. It rose to 53.9 from 53.8 in May. However, this remains below trend and the pick-up comes from a low base after April’s and May’s figures were disrupted by public holidays. Worryingly, the pace of new business expansion eased for a second month in June, which suggests the outlook for the services sector, the largest part of the UK’s economy, is extremely weak.

Although the pound bounced to 1.6070/80 on the back of the news this rally is built on shaky foundations. We are extremely bearish for sterling, but although it is holding up versus the dollar, it remains weak against the Swiss franc, the Swedish krone and the Aussie dollar – all strong currencies in the G10. This week’s Bank of England meeting is unlikely to boost the pound as the Monetary Policy Committee seems to have moved even further away from a rate hike in recent weeks.

Another story that has picked up some traction is Moody’s warning that Chinese banks’ credit outlook could turn negative. Recently we have been preoccupied by credit risk in Europe, now the focus may shift to China where local government debt burdens may be higher than anticipated to the tune of half a trillion dollars. Due to this, local banks’ non-performing loan ratios may be as high as 8-12 per cent Moody’s said, and China needed to come up with a clear plan to mitigate against these risks.

When China is coming under the credit rating agencies’ spotlights it’s clear to see that unsustainable debt burdens will no longer be tolerated. We are moving into a new epoch after the 2008 credit bust where all governments and financial regulators across the world will need to see a dramatic shift in the way they monitor debt levels.

Elsewhere, the Swedish Riksbank hiked rates as expected today to 2 per cent. Two of the bank’s members voted against the hike and the bank’s growth and inflation forecasts were revised slightly lower. Its interest rate forecast remained stable at just over one further hike this year. Even though there are signs that growth is coming off the boil in Sweden, second round inflation effects have been building. This makes this autumn’s round of wage negotiations crucial, as any signs that pay packets are getting bigger may cause the Riksbank to retaliate with a faster pace of monetary tightening.

The Reserve Bank of Australia (RBA) kept rates on hold early this morning as the market expected. The accompanying statement was viewed as being fairly neutral. The RBA noted that growth had slowed, although it was expected to pick up later in the year. However, the Bank downplayed inflation risks, suggesting that over the medium-term inflation should come back to the target rate. Thus it concluded that the 'current mildly restrictive stance of monetary policy' was appropriate.

Kathleen Brooks is research director at Forex.com

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