European Summit Deal Fails to Boost Market Confidence as Moody’s Issues Downgrade Warnings

Wall St. Cheat Sheet

A European summit deal to tighten fiscal rules in the euro zone failed to restore financial market confidence after Britain blocked a major treaty change, forcing euro-zone countries to negotiate a fiscal accord outside the Union without the support of Europe’s second-largest economy.

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Twenty-three of 27 leaders representing each state in the union agreed to pursue tighter integration with stricter budget rules at a summit in Brussels on Friday, but the did little to restore market confidence after Moody’s said it may downgrade the sovereign ratings of some European Union countries in coming months. Last week, Standard & Poor’s put 15 of the 17 euro members on watch for a possible downgrade.

Moody’s said on Monday that because last week’s summit did not produced decisive initiatives and left the euro area prone to further shocks, it will revisiting the ratings of EU nations in the first quarter of 2012. Also, Standard & Poor’s put more pressure on the region Monday, with its chief economist saying time was running out for the single-currency bloc to resolve shock to get it moving.

The euro fell today, stocks slid, and borrowing costs for Italy and Spain rose, forcing the European Central Bank to step in. Legal uncertainty surrounding the deal and the absence of an unlimited financial backstop for the single currency quickly reversed Friday’s initial market rally.

Traders said the ECB intervened to buy short-term Italian debt after yields spiked Monday, though ECB sources told Reuters last week that purchases would remain limited with a maximum ceiling of 20 billion euros a week. Rumors of a “big bazooka” to shock markets were quickly quashed last week.

However, despite the ECB’s intervention, Italian 5-year bond yields shot up past the 7 percent danger level that ultimately forced Greece, Portugal, and Ireland to seek bailouts, while 10-year yields spiked above 6.8 percent. Spanish 10-year yields topped 6 percent, though demand for short-term paper drove Italian one-year borrowing costs down just below 6 percent.

“Let’s not raise expectations too high, there will be more summits,” said credit ratings agency Standard & Poor’s chief European economist Jean-Michel Six. “Time is running out and action is needed on both sides of the equation, on the fiscal and monetary side.”

Standard & Poor’s argued that the deepening crisis and looming recession will increase governments’ potential liabilities while reducing their ability to cope with them. If some of the euro’s AAA-rated members were to be downgraded, it would call into question the solidity of the euro zone’s rescue fund, which would likely suffer a similar fate, said S&P.

“There is probably yet another shock required before everyone in Europe reads from the same page, for instance a major German bank experiencing difficulties in the market,” Six said. “Then there would be a recognition that everyone is on the same boat and even German institutions can be affected by this contagion.”

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Michael Leister, rate strategist with German bank WestLB in Dusseldorf, said the summit did little to restore market confidence because the ECB did not take it as a signal to take stronger action. “The question is will this help to stabilize sentiment? I don’t believe so, given that those comments from [ECB President Mario] Draghi ruling out a bazooka during the ECB conference are still weighing on spreads,” he said.

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