Moody's Investor Service cut Portugal's debt rating by two notches on Tuesday, saying its growth prospects were weak and it might need new austerity measures next year to hit tough fiscal targets.

The cut to A1, with a stable outlook, briefly sent the euro lower, but broad market reaction was relatively muted as Moody's made up ground with rival agency Standard & Poor's, which still rates Portugal two grades lower at A-.

It doesn't have the same impact as it would if the likes of S&P were to downgrade, given the move only brings (Moody's) in line, said Sean Maloney, rate strategist at Nomura.

Portugal's finance ministry said the cut was expected.

S&P cut Portugal by two notches in April and put a negative outlook on its rating.

The gap in the pace of ratings changes by the two agencies echoed their treatment earlier this year of Greece, another debt-burdened country on the euro zone periphery. S&P cut Greece to 'junk' status in April with Moody's not following suit until June, when it downgraded by four notches.

The premium investors demand to hold 10-year Portuguese bonds rather than safer German Bunds rose slightly, edging up 5 basis points to 290 bps from Monday's settlement level.

EYE ON STRESS TESTS

Portugal's finance ministry said in a statement the downgrade had been expected by the markets, saying Moody's was realigning with other agencies.

The stable outlook signaled Moody's confidence in the current economic policy strategy of the Portuguese government.

Filipe Garcia, economist with consultants Informacao de Mercados Financeiros in Porto, agreed there was no perception of a deterioration in the financial situation or of great difficulties in the treasury.

But it is still a warning about the need for structural reforms in the economy, because, Portugal's problem ... is more economic and structural.

Diego Iscaro, an economist at IHS-Global Insight in London said that while the downgrade had been expected and a stable outlook was good news, investors should focus on how Portuguese banks will fare in the Europe-wide stress tests on major lenders due for publication later this month.

Going forward, I'd keep a close eye to how the Portuguese banks perform in the stress tests being currently carried out. I believe that any negative surprise there would have a larger impact that today's downgrade, he said.

On Monday, Treasury Secretary Carlos Pina told Reuters tests performed so far pointed to a solid and robust banking system without capital problems.

At 1010 GMT, shares in Portuguese banks were higher, though lagging the European banking sector.

SUSTAINED GROWTH

Moody's said in a statement after a rating review that started in May it expected the Portuguese government's debt metrics to worsen for at least two to three years, with the debt-to-GDP ratio eventually approaching 90 percent.

The agency said it remained concerned about the economy's prospects, which were likely to remain relatively weak unless structural reforms bore fruit over the longer term.

The finance ministry said the priority given to fiscal consolidation might not guarantee a quick recovery of economic activity, but consolidation was required for a sustained economic growth.

Anthony Thomas, vice president of Moody's Sovereign Risk Group, told Reuters that Portugal remained in the high end of investment grade and a stable outlook meant that there was no revision planned for at least 12 months.

We think that upside risks offset downside risks, but while the government's budget consolidation targets for this year looked credible, there is a strong pressure ... to meet 2011 targets and we believe it will come up with more measures in the 2011 budget.

The government seeks to cut the budget deficit to 7.3 percent this year from last year's 9.4 percent and then to 4.6 percent in 2011.

European Central Bank President Jean-Claude Trichet said earlier on Tuesday in a newspaper interview the world needed more than three major credit ratings agencies because their actions exacerbate market swings, and financial markets had underestimated the capacity of the euro zone to react to the debt crisis.

(Additional reporting by Sergio Goncalves, Shrikesh Laxmidas, Filipa Lima and William James in London; editing by John Stonestreet)

Portugal