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Euro Falls as Moody's Downgrades Italy to A2 with Negative Outlook

Euro Falls as Moody's Downgrades Italy to A2 with Negative Outlook

2011-10-04 21:02:00
Christopher Vecchio, CFA, Sr. Currency Strategist
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THE TAKEAWAY: Moody’s Downgrades Italy > Sovereign Crisis Deepens > Euro Bearish

Moody’s Investor Service issued yet another downgrade for an indebted Southern European nation, moving Italy’sgovernment bond rating three notches lower to A2 from Aa2. Similarly, a ‘negative outlook’ was tacked onto the future position of Italian government debt.

In the wake of the news, the end of day rally in favor of the Euro, on commentary by European Union official Olli Rehn suggesting that Euro-zone finance ministers could do more to avert the sovereign bond crisis, was cut abruptly short. Euro-based pairs, in particular the EUR/JPY and EUR/USD, plummeted following the announcement. The EUR/USD skid 50-pips immediately following the announcement, but was finding bids higher thereafter, cutting its losses in half.

EUR/USD 1-minute Chart: October 4, 2011

Euro_Falls_as_Moodys_Downgrades_Italy_to_A2_with_Negative_Outlook_body_Picture_1.png, Euro Falls as Moody's Downgrades Italy to A2 with Negative Outlook

Charts created using Strategy Trader– Prepared by Christopher Vecchio

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

The downgrade reflects the weight of these growing risks relative to some positive credit attributes. These include a lack of significant imbalances in the economy or severe pressure on private financial and non-financial sector balance sheets, as well as the actions undertaken by the government over the summer. Moody's notes that the size of the rating action is largely driven by the sustained increase in the country's susceptibility to financial shocks due to a structural shift in market sentiment regarding euro-area countries with high debt burdens. A country's susceptibility to shocks is a key factor under Moody's sovereign methodology.

The negative outlook reflects ongoing economic and financial risks in Italy and in the euro area. The uncertain market environment and the risk of further deterioration in investor sentiment could constrain the country's access to the public debt markets. If such risks were to materialise and the long-term availability of external sources of liquidity support were to remain uncertain, the country's rating could transition to substantially lower rating levels.

Looking back, the timing of the announcement comes of no surprise. Earlier in the day, European Union official Olli Rehn noted that Euro-zone financial ministers could act in a more “coordinated” effort to stem the Euro-zone debt crisis. The quotes sent risk-correlated assets parabolic, with the Dow Jones Industrial Average jumping 400-points from its intraday lows.

It should be of note that on July 12, when Moody’s cut Irish debt to Ba1, Euro-zone officials were out ahead of the announcement saying that they “unconditionally” support their members, while the European Central Bank was rumored to have been purchasing Italian debt. This led to a sharp end of day rally in the Euro, similar to today. If history repeats itself here (it may very well not), it should be noted that the Euro rallied in the days following the Ireland announcement, as market participants took to the commetary rather than the substantive downgrade as a guide.

--- Written by Christopher Vecchio, Currency Analyst

To contact Christopher Vecchio, e-mail cvecchio@dailyfx.com.

Follow Christopher on Twitter at @CVecchioFX

To be added to Christopher’s e-mail distribution list, send an e-mail with subject line "Distribution List" to cvecchio@dailyfx.com.

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