Why Fitch Downgrade of Portugal is So Damaging for Euro

With rating agency Fitch downgrading Portugal’s sovereign debt rating and Germany continuing to whine about bailing out Greece, who can blame forex traders for dumping euros? A flight to quality pushed the euro to a 10 month low against the U.S. dollar and now there is no major support in the EUR/USD until 1.30.

Why a Downgrade is so Damaging

Downgrades of sovereign debt ratings are a very big deal but in an environment where investors are already weary of holding let alone buying euros, Fitch’s decision to lower Portugal’s rating added salt to the wound. It served as a harsh reminder that even if EU leaders come to an agreement on a bailout package for Greece, other countries in the Eurozone still need assistance. This may even be a good reason why EU leaders need to craft the financial aid mechanism very carefully because if it is too generous, other countries could ask for similar support. Fitch’s decision also reminds everyone that there is always more than one cockroach in the closet.

This morning, Fitch lowered its rating for Portugal from AA to AA- with a negative outlook which means further downgrades are possible. Their reason for the downgrade is the same as the reasons for every sovereign downgrade that we have seen over the past few months - “significant budgetary underperformance” in 2009. According to the Associate Director of Fitch’s sovereign team “A sizeable fiscal shock against a backdrop of relative macroeconomic and structural weaknesses has reduced Portugal’s creditworthiness,” “Although Portugal has not been disproportionately affected by the global downturn, prospects for economic recovery are weaker than [euro-zone] peers, which will put pressure on its public finances over the medium term.”

Although Portugal is much healthier than Greece who has a Fitch rating of BBB+, the downgrade is further embarrassment for the Eurozone and gives investors another reason to bail out of euros. A credit rating reflects the risk of default. Therefore a lower credit rating means that a country is at greater risk of defaulting on their debt. The greater the default risk, the more it will cost the country to borrow. On a local level, we expect investors to shift their money out of Portuguese debt and into countries with a higher credit rating such as Germany or even outside of the Eurozone. At the same time, downgrades in other countries is positive for the U.S. dollar because the greenback attracts anyone looking for quality.

Room for Euros to Fall

The euro has plenty of room to fall on a technical basis and last week, short euro positions in the futures market decreased significantly on profit taking. These same traders who have moved to the sidelines could return, providing the EUR/USD with new sellers. Even though the EUR/USD is vulnerable to a short squeeze after such a deep sell-off, we still believe that the currency pair could continue to fall.

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