Ireland: Another Day, Another Downgrade

by Win Thin

Here are some more thoughts regarding the Fitch downgrade of Ireland by three notches to BBB+. The agency cited the mounting costs of the banking system rescue as a major factor behind the move, and is consistent with what we wrote earlier this week: “Though Q3 was relatively quiet with regards to developed country downgrades, Ireland moved back into the spotlight in Q4 as ongoing revisions to the cost of the government’s rescue of the banking system continued to weigh on its outlook. As those costs have mounted, Ireland’s implied rating fell sharply in this round to BBB/Baa2/BBB from A-/A3/A- previously. As such, its current ratings of A/Aa2/A+ are very vulnerable to significant downgrade risk.” With this move, Fitch is now closest to our own view on Ireland, but we think more downgrades are likely even though Fitch put the outlook at stable. Fitch analyst said he doesn’t expect Ireland to default, but admitted that “there is obviously a chance.”

It’s quite unbelievable that Moody’s still has Ireland at Aa2 (equivalent to AA), though we note that last month, that agency warned of “multi-notch” downgrades to its Aa2 rating, noting that the aid plan will “crystallize more bank-contingent liabilities on the government balance sheet, and increase the Irish sovereign’s debt burden.” It noted that developments have worsened since the rating was first put on review for possible downgrade back in October. Moody’s predicted that Ireland would remain at investment grade. While we agree with that assessment now, we cannot say this will continue to hold with any certainty. While our ratings model correctly predicted significant downgrades to Western Europe as far back as mid-2009, we note that implied ratings have become a moving target as the macro backdrop for the periphery continues to deteriorate. For instance, Ireland had an implied rating of A-/A3/A- back in June. The agencies are trying to play catch-up, something we saw during the Asian crisis as well. We continue to see downgrade risks ahead for Spain, Greece, and Portugal too.

Ireland 10-year yield is actually down 2 bp on the day, as markets appear to have priced in the downgrade news already. However, given that ongoing ECB bond purchases are distorting yields and spreads, we think it is more instructive to note that the 5-year CDS price is up 11 bp on the day to 542 bp. While peripheral bond yields and CDS prices have fallen since last week, they remain highly elevated and subject to an ongoing negative news stream. The downgrade story will remain in play for the periphery for much of 2011.