Expect U.S. investors to cling to their dollars after Standard & Poor’s downgraded nine euro zone countries and one of the region’s two rescue funds, stoking worries about lending to European banks.
The European Central Bank has committed to pumping in huge sums of cash to buy time for banks to raise capital in case of losses from exposure to euro zone sovereign debt, but European leaders have not developed a comprehensive program that convinces investors that they could agree on tools to prevent the region’s debt problem from spiraling into a global crisis.
S&P stripping France, Austria and the European Financial Stability Facility of their top-notch AAA-rating in recent days, albeit widely expected, was a stark reminder that this problem poses huge risk to the global banking system, analysts said on Tuesday.
The rating agency’s downgrades belied evidence of a reduction in money market stress since the beginning of 2012. Key market gauges including unsecured interbank rates and risk premiums have declined from their year-end peaks, they said.
‘It’s going to create more pressure on European banks, which they don’t need right now,’ said Jeremy Hare, managing director of investments at Gilford Securities in Philadelphia, which manages about $1 billion in assets.
The EFSF relies on guarantees from euro zone governments to borrow cheaply and lend the money on to countries cut off from the markets to give them time to reform. Its maximum lending capacity, based on the guarantees, is 440 billion euros, assuming bonds issued by the EFSF have a AAA-rating from S&P and the other two major rating agencies.
Still with the backing of the ECB, euro zone banks have ample cash to operate while they seek to strengthen books loaded with loans to Italy, Spanish and other peripheral countries.
‘A lot of people think it will be okay for a while, but the wounds are so deep,’ said Lance Pan, director of investment research and strategy at Capital Advisors Group in Newton, Massachusetts.
On Tuesday, euro zone banks borrowed 126.88 billion euros at the weekly tender, about 16 billion euros more than their take-up last week and above the 100 billion euros forecast by analysts in a Reuters poll.
Euro zone banks have also been able to obtain short-term dollars in the secured, repurchase market, while peripheral zone countries have generally fetched solid demand at their debt auctions so far in 2012, analysts said.
The ECB’s liquidity measures and some stabilization in money markets have reduced fears of another global credit crunch, but investors remain defensive.
‘Liquidity risks by no means have been eliminated because liquidity provisions are no substitute for private capital nor the transference of risk to either the private-sector or the central bank,’ Anthony Crescenzi, portfolio manager at Pimco wrote in a client note on Tuesday.
Until European leaders deliver a credible plan to contain the debt crisis, money managers will limit their exposure to the euro zone. They will stick to Treasury bills, agency discount notes and other low-risk U.S. government-backed securities as vehicles to hold their cash, even though they are yielding nearly nil.
‘We are telling clients it’s better to preserve capital than to reach’ for yields, said Gilford’s Hare.
By Richard Leong