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THE TAKEAWAY: Moody's Downgrades Portugal > Contagion Spreading > EUR Bearish

Moody’s Investor Service issued another downgrade for another indebted Southern European nation, shifting Portugal’s long-term government bond ratings to Ba2 from Baa1, and issued yet another negative outlook to the ratings. Today’s decision reflects the results for the review on a possible downgrade from a process that started on April 5, 2011.

In the wake of the news, the rally to risk-aversion that started earlier in the day on news that the rating agencies could potentially classify the bailout of Greece as a “selective default” continued, with Euro-based pairs, particular the EUR/CHF, EUR/JPY and EUR/USD pairs, plummeting across the board. The EUR/CHF pair had depreciated over 100-pips on the news, at the time this report was written.

Euro-Franc 1-minute Chart: July 5, 2011

Euro_Falls_as_Moodys_Downgrades_Portugal_to_Ba2_Outlook_Negative_body_Picture_4.png, Euro Falls as Moody's Downgrades Portugal to Ba2; Outlook Negative

Charts created using Strategy Trader– Prepared by Christopher Vecchio

In the release, Moody’s noted the following two reasons for today’s downgrade:

1. The growing risk that Portugal will require a second round of official financing before it can return to the private market, and the increasing possibility that private sector creditor participation will be required as a pre-condition.

2. Heightened concerns that Portugal will not be able to fully achieve the deficit reduction and debt stabilisation targets set out in its loan agreement with the European Union (EU) and International Monetary Fund

(IMF) due to the formidable challenges the country is facing in reducing spending, increasing tax compliance, achieving economic growth and supporting the banking system.

As noted, when considered together, Moody’s felt that there is an “increasing probability” that Portugal won’t be able to borrow at sustainable rates in the capital markets, all the way into the second half of 2013, and “some time thereafter.” It was also stated in the release that a potential scenario for a haircut on existing loans would rise for lenders, as such a situation would “necessitate further rounds of official financing.”

Furthermore, the decision noted that “Although Portugal's Ba2 rating indicates a much lower risk of restructuring than Greece's Caa1 rating, the EU's evolving approach to providing official support is an important factor for Portugal because it implies a rising risk that private sector participation could become a precondition for additional rounds of official lending to Portugal in the future as well.

Written by Christopher Vecchio, Currency Analyst

To contact the author of this report or be added to his distribution list, please send inquiries to: cvecchio@dailyfx.com

Follow Christopher Vecchio on Twitter: @CVecchioFX