S&P Moves, Greek Debt Renew Pressure on Eurozone

(Reuters) - Financial markets are unlikely to be derailed by mass euro zone downgrades, but with Greek debt talks at an impasse, pressure has been loaded on the bloc to shore up its defenses and glimmers of optimism from last week have been firmly doused.

With the United States and Japan already downgraded from AAA, the likes of France and Austria are in good company and Standard & Poor's ratings cuts had been flagged in December. Nonetheless, the upbeat tone that surrounded last week's strong Spanish bond auction now seems a distant memory.

The euro zone crisis is now dominating market activity again, after a period in which better economic news from the U.S., and easier monetary policy in China had helped markets move higher, said Dominic Rossi, chief investment officer, equities, at Fidelity Worldwide Investment.

U.S. markets are closed Monday for the Martin Luther King holiday, but the euro zone will not have to wait long for a test of investor appetite.

France will attempt to sell up to 8 billion euros of debt on Thursday and Spain will tap the market again after a successful bond auction last week where it raised twice as much as expected at lower borrowing costs.

Analysts put that success down to the flood of cheap 3-year money the European Central Bank pushed into the banking system in December. It will make the same offer in February, fostering hopes that it can avert a credit crunch and helped bolster struggling euro zone debt issuers to boot.

But the twin blows of the serial S&P downgrades and the stalled Greek bond swap talks have cast another pall of gloom. This time, Spain will try to sell longer-term debt, which could be tougher.

While the market impact of the downgrades is unlikely to be very significant in the short term, they serve as a stark reminder that the euro area sovereign crisis is here to stay, analysts at RBS said. We continue to expect the crisis to deepen eventually leading to further widening in spreads across countries vis-a-vis Germany.

After downgrading nine of the euro zone's 17 countries, S&P said it would decide shortly whether to do the same for the currency area's EFSF bailout fund. Ratings cuts for commercial banks are probably imminent too.

Speculation around an EFSF downgrade will now grow, complicating its ability to raise capital and displace the ECB in the sovereign bond purchasing program, Rossi said. Both the ECB and the IMF will get sucked further into central roles.

A senior euro zone official said the EFSF could retain its AAA rating with Standard & Poor's through higher guarantees from the euro zone's remaining triple A countries or lower lending capacity.

Negotiations with the banks on a bond swap scheme designed to eat into Greece's colossal debts are expected to restart on Wednesday with Athens warning of catastrophe if they fall apart.

Without a deal, a planned 130 billion euros Greek bailout of which the bond swap is a vital part will be fundamentally holed, raising the prospect of default in March when massive bond payments are due. That, rather than the long-anticipated S&P downgrades, looks to be the bigger worry for investors.

At this stage, there is a growing risk of a coercive rather than voluntary debt restructuring, even though the latter is still our base case, said Joachim Fels, economist at Morgan Stanley.

SENSE OF URGENCY

Euro zone leaders do seem to be gripped with a sense of urgency although they have failed for nearly three years to get on the top of the sovereign debt crisis born in Greece.

Rather than launch a broadside at S&P, German Chancellor Angela Merkel Saturday said she and her fellow leaders must act more swiftly to impose common fiscal rules and get a permanent rescue fund up and running.

Although nobody is excited about the S&P decision, the step may actually help to get a quick agreement on the fiscal compact, a German government official said.

While not expecting a euro zone breakup, S&P blamed its leaders for focusing too much on cutting debts and not sufficiently on competitiveness and growth.

The ratings agency, and many economists, say austerity for its own sake will be self-defeating - deepening economic downturns and cutting government revenues needed to lower debt.

Market participants are worried about a vicious circle in which they tighten, growth weakens, the deficits get bigger despite the efforts to tighten, said Jim O'Neill, chairman of Goldman Sachs Asset Management.

Ahead of an EU summit on Jan. 30 which will attempt to alight upon a growth strategy, shuttle diplomacy continues apace this week.

French President Nicolas Sarkozy sees Spain's Mariano Rajoy in Madrid Monday. Italian Premier Mario Monti visits Britain's David Cameron in London Wednesday, then hosts Sarkozy and Merkel in Rome at the end of the week.

Aside from Greece it is Italy, facing massive bond repayments over the next three months, which poses the biggest threat to the euro zone. It was downgraded two notches by S&P.

More than the moves on France and Austria, which are relatively symbolic and to a large extent reflected in prices already, the Italian downgrade might be key going forward, said Laurent Fransolet at Barclays Capital. Italy is at BBB+ now by S&P, but is on watch negative by Fitch and on negative outlook by Moody's, and therefore some further downgrades are likely.

The more upbeat view is that, in the end, Europe's leaders will not allow the whole edifice to collapse, despite German and ECB reservations about many of the policy options. But even optimists say uncertainty will reign for some time.

Some day the markets will wake up and see that Europe is not going to allow a collapse. If they get through the next six months, you can see the tide turning. Sentiment changes very rapidly, said John Fitzgerald of the Economic and Social Research Institute, a Dublin-based think tank, who also sits on the board of the Irish central bank.

Europe is the biggest threat to the global economy, JP Morgan's chief executive Jamie Dimon told German newspaper Die Welt's Sunday edition. I thought Europe would muddle through. I still believe that, he was quoted as saying.

(Additional reporting by Andreas Rinke, Alex Smith, Nigel Stephenson, Robin Emmott, Jamie McGeever and Adrian Croft)