Moody's Downgrades Italy's Sovereign Rating Two Notches

Late Thursday, Moody's Investor Services downgraded the sovereign credit rating of Italy to Baa2 from A3, citing a weaker economic outlook and rising funding costs. Moody's left Italy on negative outlook and maintains its short-term rating of Prime 2. The rate cut places Moody's rating one notch below that of S&P and two notches below Fitch.

From Moody's: "The decision to downgrade Italy's rating reflects the following key factors:

"1. Italy is more likely to experience a further sharp increase in its funding costs or the loss of market access than at the time of our rating action five months ago due to increasingly fragile market confidence, contagion risk emanating from Greece and Spain and signs of an eroding non-domestic investor base. The risk of a Greek exit from the euro has risen, the Spanish banking system will experience greater credit losses than anticipated, and Spain's own funding challenges are greater than previously recognized.

"2. Italy's near-term economic outlook has deteriorated, as manifest in both weaker growth and higher unemployment, which creates risk of failure to meet fiscal consolidation targets. Failure to meet fiscal targets in turn could weaken market confidence further, raising the risk of a sudden stop in market funding."

Yields on benchmark 10-year bonds rose on Friday, reflecting the rate cut. Yields climbed as high as 6.0800 percent, and they stand at 6.05800 percent as of writing. However, the spread of Spanish 2-year bond yields, which are a good measure of short term funding strength, over Italian 2-year bonds actually rose, indicating that markets still find Italy safer than Spain as an investment.

Italy and Spain face very different problems, which the action of the two bonds indicates. Italy has a large debt load, with debt-to-GDP above 120 percent at the end of 2011. However, Italy is running a structural government surplus, meaning that, before its interest expense, it is not spending more than it takes in as revenue. Thus, its budget path is sustainable should interest expenses not spiral higher. Spain, however, has been running large structural deficits and needs to either increase revenue or decrease expenses to be sustainable.

Italian shares rose in late Milan trading, with the benchmark MIB Index rising 1.0 percent. The Spanish Ibex rose as well, climbing 0.5 percent in Madrid trading.

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