Friday afternoon, everyone was watching S&P to find out whether they’d make good on their statements about downgrading 13 separate European countries. At stake, in particular, were the fates of France, Spain and Italy- all of which were at risk of being knocked down a full two notches. It didn’t happen… yet. What did happen was a collective realization that Friday’s risk on environment may have been floating on nothing but European hot air, as stocks across the board came tumbling down after Fitch and Moody’s both issued their own stern words for our friends across the pond.
A ratings agency cannot just say, “downgrade the European Union,” (can they?) but they can downgrade individual member states. The reason everyone is tensely awaiting the verdict from S&P is that, should those negative watch labels turn into actual downgrades, it will have the same functional effect as giving the thumbs down to the Union as a whole. Then what?
On one hand, investor confidence in the EU’s ability to pull through this is already shaky at best, so the formal downgrade of debt hardly seems all that troubling when the countries in question already have debt trading as if these potential downgrades were already a reality. On the other hand, any firms holding Euro zone debt which have mandates to only hold the highest rated paper would be forced by a downgrade into a mass liquidation of those positions (further driving down prices and causing further losses on those positions). That is the big fear here- that a downgrade sparks a chain reaction of selling and margin calls which precipitate more selling, and so on.
Then there are those that are hoping it may not do anything at all in terms of massive sell offs. When the U.S. faced their downgrade earlier this year, treasuries continued on their merry way, and despite an initial sell off – equity markets remained roughly where they were pre-downgrade. Could the EU be so lucky?
Possibly, but even though the U.S. downgrade at the end of summer may not have tanked demand for U.S. treasuries, it was not without impact. As Zerohedge explains:
By now, most sane market observers and participants understand that perhaps, just perhaps, everything we believed about neoclassical economics is not without fault. In fact it is possible that the entire macro-economic safety net of Keynesian policy has come into question… when S&P downgraded the mighty USA’s credit rating, they proved the impossible is possible… the huge rise in volatility and correlation appear to suggest the market is indeed terrified of its own shadow.
The proof? Two charts that sum things up quite nicely from the same post. The first depicts the massive surge in volatility since the U.S. downgrade, and the second indicates the continuous rise of expected correlation in the markets- or the expectation of more risk on/risk off days. In other words, the markets have decided that crazy is the new norm.
So what happens if the European downgrade actually happens? If the downgrade of the U.S. triggered this anticipation of perpetual crazy, what comes next? Even more volatility and craziness?