Last call for the ECB

Once again the markets have blown Standard and Poor's a raspberry by lowering the interest rate on French debt after it was downgraded.

Last night France successfully sold €8.6 billion of debt at lower yields than before S&P downgraded France's credit rating from AAA to AA on Friday. That sparked a moderate rally on sharemarkets in Europe.

In August S&P did the same thing to the United States (AAA to AA ), and since then the yield on its 10-year bonds has fallen from nearly 3 per cent to 1.86 per cent this morning. It seems an S&P thumbs down is a ringing endorsement.

Actually, it's simply that safe haven investments are getting harder and harder to find, so AA is the new AAA.

Meanwhile, this morning S&P also downgraded the European Financial Stability Fund from AAA to AA because of the downgrades of its guarantor countries, but that didn't – and won't – have any impact either.

Essentially, the S&P actions were in the market and everyone pretty much agrees with the reasons for it: that European policymakers are focusing on the wrong thing – fiscal imbalances instead of competitiveness divergences and external imbalances.

The real action last night was in Portugal, as its bond yield climbed 200 basis points to 14.48 per cent and the price fell to 48 per cent of face value, but this is more to do with what's going on in Greece than the fact that S&P downgraded Portugese debt two notches to junk (from BBB- to BB).

Although S&P has highlighted the underlying problems with Europe, the immediate issue facing the eurozone is Greece, not credit ratings. On Friday, the negotiators for private bondholders walked out of the meetings where Greece's lenders were trying to thrash out a deal to avoid a default, and now talks are at a standstill.

The private bondholders are being asked to 'voluntarily' swap €203 billion worth of Greek bonds for new securities worth half that amount. They had almost agreed, but the ground kept shifting under everyone's feet. Specifically, the Greek economy shrank by 6 per cent last year instead of the 4 per cent predicted, so the prediction of another 4 per cent contraction in 2012 is not only dire enough, but now hard to believe.

Greece is due to pay €14.4 billion in bond repayments on March 20th. Its banks need to be recapitalised as well, to the tune of €40 billion, and apparently €30 billion is needed as a sweetener to the bondholders to get them to accept the 50 per cent haircut.

That means not only do the private bondholders have to cop a €100 billion loss, the public sector – Germany/ECB/IMF – has to produce €80-90 billion in new bailout cash within two months, to avoid default. Hugo Dixon in his Reuters column today says the public sector will soon have €300 billion at stake in Greece, which is a nightmare for all concerned.

So far the European Central Bank has been holding things together in Europe with its program of three-year loans to banks at 1 per cent interest. All up, €489 billion were lent before Christmas and this money is now being recycled back into Italian and French bonds, among other things, which is helping both the countries and the banks.

But the problems in Greece and the incipient contagion affecting Portugese debt this morning are a pointer to problems in the next few months that were identified by S&P in its statement on Friday.

The countries that are subject to fiscal austerity – Italy, France, Spain – are going into recession. Germany's exporters will inevitably see orders dry up, just as the nation's banks deal with Greek write-downs and uncertainties elsewhere. It is hard to see Germany avoiding a recession as well.

As S&P said on Friday: "…we believe that a reform process based on a pillar of fiscal austerity alone risks becoming self-defeating, as domestic demand falls in line with consumers' rising concerns about job security and disposable incomes, eroding national tax revenues.”

It is hard to avoid the conclusion that the only way the eurozone crisis will be resolved is through massive debt monetisation by the ECB. It has become a little bit pregnant with the 1 per cent three-year loans; it will soon be time to go all the way.

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