Portugal Downgraded, More Cuts Likely

By Win Thin

Moody’s cut Portugal by two notches to A3 and kept a negative outlook despite the recently announced fiscal tightening and despite the tentative plan to expand the EFSF. This downgrade really shouldn’t come as any surprise. As we wrote just last week, “Moody’s A1 and Fitch’s A+ ratings for Portugal need to be adjusted downward as our model rates it at A-/A3/A-, while S&P’s A- looks correct.” The only thing we’d add is that it looks like Portugal will deteriorate further in the next quarterly update of our model (out later this month) to the BBB+/Baa1/BBB+ area, and so the negative outlook is justified and further cuts appear likely. Portugal clearly will remain in the market spotlight as its 10-year yield remained above 7% for the 28th straight day on Tuesday. Furthermore, Portugal’s 5-year yield stayed above 7% for the 19th straight day and the 2-year stands at around 6.3%. This continues the pattern that we saw with Greece and Ireland. In both those cases, the 10-year yield was the first to break above 7%, with the 5-year and then the 2-year yields breaking above that level eventually. It is noteworthy is that the rescue packages for those two countries have done nothing to substantially lower their borrowing costs, with 10-year yields still substantially above 7% for both. With contagion showing no signs of abating, we think Portugal is doomed to the same fate.

What about Spain? Spain 10-year yields are the next highest in the periphery and are now around 5.2%. While one might be tempted to say that Spain has decoupled from the rest of the periphery, we note that Ireland 10-year yields were around 4.6% right after the Greece rescue package was announced, and that Portugal 10-year yields were just above 5.9% right after the Ireland rescue package was announced. If market sentiment on the periphery remains negative after the upcoming summit and likely Portugal bailout, then Spain yields may resume their upward creep. The timeline between rescues appears to have shortened, with close to 7 months between Greece and Ireland but likely down to around 4 months between Ireland and Portugal if current trends continue.