DUBLIN (Reuters) - Moody's moved a step closer to returning Ireland to investment grade on Friday by upgrading its sovereign rating to stable from negative, but warned the government against easing off on austerity.
Moody's is the last of the three main credit rating firms to class Irish government debt as "junk", rating it Ba1, and the outlook change may fuel hopes of an upgrade before the country exits its 85 billion euro EU-IMF bailout later this year.
"It's a very significant step and you will see Irish bond yields move significantly lower on this first thing on Monday morning, there is absolutely no doubt about that," said Ryan McGrath, a Dublin-based bond dealer with Cantor Fitzgerald.
Moody's cited a return to modest growth and the improvements in Ireland's main export markets and its success in raising funds from the markets in recent months as grounds for increased optimism.
But it warned the government that a relaxation of austerity measures could undermine this.
"Downward pressure would develop on Ireland's government rating ... if the country's fiscal consolidation process were to falter," the Moody's statement said.
Ireland last year beat its deficit target under its EU/IMF bailout, leading to calls by government ministers for a more modest package of spending cuts and tax hikes in a budget to be unveiled next month than previously agreed with its lenders.
The International Monetary Fund has indicated it wants Ireland to stick to the earlier targets. The government says it has made no final decision.
Ireland emerged from its second recession in five years in the second quarter with growth of 0.4 percent in the three months to June, with strong exports raising hopes for an improvement in the second half of the year.
"Moody's expects that the resumption of growth among Ireland's major trading partners, particularly the UK and the euro area, along with continued expansion of the US economy will support Irish growth, relative to its recent lacklustre performance," the statement said.
Ireland has made progress in borrowing money from international debt markets, selling 5 billion euros of new 10-year bonds in March.
But Moody's said it was unclear how much of this success was due to Ireland's access to bailout funds.
Moody's also praised Ireland for restoring competitiveness and attracting foreign direct investment and said it had proved less susceptible to external shocks than other struggling euro zone economies.
The upgrade in outlook, days after Standard & Poor's placed fellow bailout recipient Portugal under warning of a possible credit-rating downgrade, will help differentiate Ireland further said Cantor Fitzgerald's Ryan McGrath.
"This will help Ireland to separate itself from the rest of the peripheral basket. Traders will now start pricing in the actual upgrade," he said.
(Reporting by Padraic Halpin and Conor Humphries; Editing by Eric Walsh)