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France and Austria lost their top credit ratings in a string of downgrades that left Germany with the euro area’s only stable AAA grade as Standard & Poor’s warned that crisis-fighting efforts are still falling short.

France and Austria were cut one level to AA+ from AAA and face the risk of further reductions, the rating company said in Frankfurt late yesterday. While Finland, the Netherlands and Luxembourg kept their AAA ratings, they were put on negative watch. Spain and Italy were also among the nine nations downgraded.

“In our view, the policy initiatives taken by European policy makers in recent weeks may be insufficient to fully address ongoing systemic stresses in the euro zone,” S&P said in a statement.

The first gauge of the report’s impact will come in two days when France sells as much as 8.7 billion euros ($11 billion) in bills. History shows yields may not rise much, at least initially. Ten-year yields for the nine sovereign borrowers that lost their AAA ratings between 1998 and the U.S.’s downgrade in August rose an average of two basis points in the following week, according to JPMorgan Chase & Co.

Treasuries Rise
While S&P’s announcement came after the close of trading in Europe, U.S. Treasuries rose, pushing yields to the lowest levels this year as investors sought the safety of U.S. government debt. Yields on 10-year notes fell six basis points, or 0.06 percentage point, to 1.87 percent at 5 p.m. New York time. They touched 1.83 percent, the lowest level since Dec. 20, according to Bloomberg Bond Trader prices. The benchmark 2 percent security maturing in November 2021 gained 16/32, or $5 per $1,000 face amount, to 101 6/32.

S&P acted at the end of a week in which signs grew that Europe’s woes may be cresting as borrowing costs fell, evidence of economic resilience emerged and the European Central Bank said it had quelled a credit crunch at banks. While France’s downgrade may make it harder for the euro region’s bailout fund to raise money in financial markets, the immediate impact on French and Italian bond yields was muted.

“Perhaps this will now concentrate the minds of EU policy makers making them realize that no country is immune to being pulled down by the euro crisis,” said Sony Kapoor, managing director of policy advisory firm Re-Define in Brussels. “The downgrades have now been expected for weeks so this should blunt some of the impact they would otherwise have had.”

Third Year
European leaders are still struggling to tame a crisis now in its third year and convince investors they can restore budget order. Greece’s creditors yesterday suspended talks with its government having failed to agree about how much money investors will lose by swapping the nation’s bonds, increasing the risk of the euro-area’s first sovereign default.

The euro yesterday fell to its weakest in 16 months against the dollar, declining to $1.2665. The yield on Germany’s benchmark 10-year bund fell seven basis points to 1.759 percent after touching a record low on earlier speculation that S&P would maintain the nation’s AAA rating.

The yield on France’s equivalent 10-year debt rose 3 basis points to 3.055 percent, and Italy’s 10-year yield climbed 1 basis point to 6.596 percent.

‘Self-Defeating’
Authorities have still to produce “a breakthrough of sufficient size and scope to fully address the euro-zone’s financial problems” and should stump up more resources and show greater flexibility, S&P said. Officials were also chastised for focusing too much on budget cuts which could prove “self defeating” as economic growth slows, it said.

The result is that refinancing costs for certain countries may remain “elevated” and credit availability and economic growth may fade, it said. It nevertheless praised the ECB’s decision to lower interest rates and aid banks for helping avert a collapse of market confident.

Regional finance ministers sought to play down S&P’s shifts or turn them to their advantage as European leaders prepare to meet for the first time this year on Jan. 30.

“It’s not a catastrophe,” French Finance Minister Francois Baroin told France 2 television, noting his country now has the same rating as the U.S.

Schaeuble’s Comments
Wolfgang Schaeuble, his German counterpart, said the moves vindicated the decision by governments last month to bring forward a permanent bailout fund to this year from 2013 and strengthened his country’s determination to stabilize the euro region by instilling stricter budget discipline.

“We know that there’s uncertainty with respect to the euro area,” he told reporters in the northern German port city of Kiel.

The French and Austrian downgrades risk sapping the potency of the region’s current rescue program, which has a spending capacity of 440 billion euros ($558 billion). The European Financial Stability Facility, which is funding rescue packages for Greece, Ireland and Portugal partially with bond sales, owes its AAA rating to guarantees from the region’s top-rated nations. It is scheduled to sell up to 1.5 billion euros in 6- month bills next week.

The French downgrade and refusal by governments to provide more credit enhancements would still reduce the fund’s lending capacity by around a third to 293 billion euros, Trevor Cullinan, S&P’s director of sovereign ratings, said last month. It is scheduled to call for bids of up to 1.5 billion euros in 6-month bills on Jan. 16.

John Chambers, managing director of sovereign ratings at S&P, said in a Bloomberg Television interview in New York that the EFSF’s “rating rests on its guarantors, and particularly its triple-A guarantors.”

EFSF Power
“It will be interesting to see what the strategy will be regarding the EFSF,” said David Schnautz, a fixed-income strategist at Commerzbank AG in London. Downgrades could “limit the volume of AAA rated EFSF paper that could be issued, or the EFSF could begin to issue non-AAA.”

Downgrades sometimes lack bite. The yield on the benchmark U.S. government bond fell to a record 1.6714 percent on Sept. 23, seven weeks after S&P withdrew its AAA rating for the first time, citing the nation’s political process and a failure to tackle a record budget deficit.

The impasse in Greece’s debt-swap talks comes three months since officials and creditors agreed to implement a 50 percent cut in the face value of the country’s debt, with a goal of paring Greek’s borrowings to 120 percent of gross domestic product by 2020. Unresolved is the coupon and maturity of the new bonds to determine the total losses for investors.

Discussions With Greece
Proposals put forward by a committee representing financial firms have “not produced a constructive consolidated response by all parties,” the Washington-based Institute of International Finance said in a statement yesterday. “Discussions with Greece and the official sector are paused for reflection on the benefits of a voluntary approach.”

The government said the two sides will reconvene discussions next week. European governments have been pushing for the Greek debt to carry a coupon of 4 percent, a person with direct knowledge of the negotiations said this week. Private bondholders said they would accept those terms for a period of time if they were able to get a bigger payout later as Greece’s economy recovered, the person said.

The Greek bond due October 2022 rose, pushing the yield six basis points lower to 34.36 percent at 5:20 p.m. London time. The price climbed to about 20.5 percent of face value.

The first ever French downgrade strikes a blow to President Nicolas Sarkozy’s bid for re-election after he sought to protect his government’s creditworthiness by announcing tax increases and spending cuts. He trails his main rival, Socialist Party candidate Francois Hollande, by about 14 points in voting intentions for the second round of the election in May, according to a BVA poll for Le Parisien published Jan. 9.

Draghi’s View
Prior to S&P’s announcement investors had eased the costs they were imposing on Italy and Spain to borrow, sparking speculation the worst of the crisis may be passing. ECB President Mario Draghi said on Jan. 12 the central bank had averted a serious credit shortage and economy is stabilizing with data showing rebounds in German exports and French business confidence.

“This decision could upset the positive developments we’ve seen in Europe in the last few weeks,” ECB Governing Council member Ewald Nowotny said. “That’s the most dangerous thing in my view.”

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The euro dropped against most major counterparts, reaching a 16-month low versus the dollar, as Standard & Poor’s stripped France of its top credit rating.

The 17-nation currency fell for a sixth straight week against the greenback, its longest losing streak in almost two years, as S&P said on its website it lowered France’s rating one step to AA+ with a negative outlook. The euro fell to its weakest versus the yen since 2000 as talks between Greece and creditor banks were put on hold. The Dollar Index climbed as U.S. stocks fell after JPMorgan Chase & Co. said profit slid.

“The rumors of the pending cuts were enough to make the euro fall off and then take stocks with it,” said John Doyle, director of markets in Washington at the currency-trading firm Tempus Consulting Inc. “Greece has been a thorn in the side of the euro for almost three years now, and it will be a continuing weight on the euro.”

The euro weakened 1.1 percent to $1.2680 at 5 p.m. in New York. It touched $1.2624, the lowest level since Aug. 25, 2010, and lost 0.3 percent over the past five days. The last time the euro dropped for six weeks was the period ended Feb. 19, 2010.

The shared currency sank 0.8 percent to 97.57 yen and touched 97.20 yen, the weakest level since December 2000. It lost 0.3 percent for the week, its third five-day decline. The Japanese currency depreciated 0.3 percent to 76.97 per dollar.

While France was downgraded, S&P affirmed the ratings of Germany, Belgium, Estonia, Finland, Ireland, Luxembourg and the Netherlands, the company said in a statement.

S&P Downgrades
Ratings of Cyprus, Italy, Portugal, and Spain were cut by two levels, S&P said. Austria, Malta, Slovakia and Slovenia were cut one step, it said.

The dollar climbed against most of its major counterparts as risk appetite faded and investors sought refuge.

“The three strongest net inflows being currently witnessed amongst global fixed-income markets are into Japanese government bonds, Swiss bonds and U.S. Treasuries,” Samarjit Shankar, a managing director for the foreign-exchange group in Boston at Bank of New York Mellon, wrote to clients. “This flight to relative safe and liquid assets is being spurred by renewed concerns about potential credit rating downgrades in the euro zone.”

Yields (USGG10YR) on benchmark Treasury 10-year notes declined to 1.83 percent, the lowest level this year, as the securities’ prices rose. Japanese 10-year notes yielded 0.95 percent, the lowest since November, and Swiss 10-year yields were at 0.79 percent.

Dollar Index (DXY)
The Dollar Index, which IntercontinentalExchange Inc. uses to track the greenback against the currencies of six major U.S. trading partners, reached 81.784, the highest since Sept. 14, 2010, after JPMorgan said fourth-quarter profit decreased 23 percent. The S&P 500 Index dropped as much as 1.4 percent before paring losses to 0.5 percent.

Greece’s creditor banks broke off talks after failing to agree with the government about how much money investors will lose by swapping their bonds, increasing the risk of the euro- area’s first sovereign default. Negotiations have “paused for reflection,” the Institute of International Finance said in an e-mailed statement today. The government said the two sides will reconvene discussions in five days.

“We’re focused on if there is going to be an agreement at all, regardless of the specifics,” said Brian Kim, a currency strategist at Royal Bank of Scotland Group Plc in Stamford, Connecticut. “The ratings could have implications for the backstop mechanism, but we’re just focusing right now on Greece.”

Bets Against Euro
Futures traders increased bets to a record high that the euro will decline against the dollar. The difference between wagers that the shared currency would fall versus those that it would rise -- so-called net shorts -- surged to 155,195 in the week ended Jan. 10, according to data from the Commodity Futures Trading Commission released yesterday.

France’s rating downgrade may threaten the potency of the region’s main bailout fund. The European Financial Stability Facility, which is funding rescue packages for Greece, Ireland and Portugal partially with bond sales, owes its AAA rating to guarantees from the euro region’s top-rated nations. A French downgrade may prompt investors to demand higher rates.

S&P put the ratings of 15 euro nations, including AAA rated Germany and France, on review Dec. 5 for possible downgrades. Moody’s Investors Service said Dec. 12 it would review European Union countries’ ratings after a Dec. 9 summit failed to produce “decisive policy measures” to end the debt crisis.

Italian Auction
The euro retreated 0.8 percent today against nine-developed nation peers tracked by Bloomberg Correlation-Weighted Currency Indexes after Italian borrowing costs declined less at a note sale than when the country auctioned bills yesterday. The dollar gained 0.6 percent, while the Swedish krona was the biggest loser after the euro, declining 0.6 percent.

Italy sold notes due in November 2014 at an average yield of 4.83 percent, down from 5.62 percent at a prior auction on Dec. 29. Investors bid for 1.2 times the amount allotted, down from a bid-to-cover ratio of 1.36 last month.

The nation’s cost of borrowing for one year dropped to 2.735 percent at a bill sale yesterday, from a 5.952 percent yield at the prior auction on Dec. 12.

“That the bid-to-cover ratio was not especially high, combined with euphoric reactions to the bill auctions yesterday, left room for disappointment,” said Shahab Jalinoos, a senior currency strategist at UBS AG in Stamford, Connecticut. “The second issue is that the Greek private-sector-involvement story continues to rumble in the background.”