Hungary's second credit downgrade to 'junk' in a month heightened risks of a full-blown market crisis, with investors anxious for clarity on whether it will push the country closer to or further away from an international aid deal.
Late on Wednesday Standard and Poor's cut Hungary's long-term rating by a notch to BB+, sending the forint currency lower and lifting bond yields.
The agency cited the centre-right government's unpredictable policies, adding to pressure on Prime Minister Viktor Orban to start official talks with the International Monetary Fund and EU about a funding backstop.
The government said the downgrade was unjustified and still expected the negotiations with lenders to go ahead in January.
Bond prices fell on Thursday, though the deputy head of the country's debt agency said he did not expect the news to spark panic selling.
"Yields are 30-35 basis points higher, but this jump came on small amount of selling...there is no dumping of assets," a fixed income trader added.
The Fidesz party led by Orban, who broke ties with the IMF in 2010 to regain "economic sovereignty, is expected to push through legislation this year which the EU has said it should withdraw, notably a central bank bill seen undermining the bank's independence.
"At the moment (Orban) is sitting in the car in head-on collision mode and is not willing to move," a diplomatic source told Reuters on Wednesday, before the S&P downgrade.
Orban is seeking a new "insurance" type financing deal, which could help Hungary retain access to market funding next year, but at the same time does not want lenders interfering with his unconventional policies to boost the economy.
"(The downgrade) could, alongside market weakness, push Hungary towards engaging more constructively with the IMF and EU. It may also serve to fast-track the negotiations," Barclays said in a note.
"But there is also a risk that Hungary's government will try to soldier on without outside financial support, instead turning to more unorthodox policy measures."
The government has stabilised its budget with a series of ad hoc taxes and nationalised pension assets since it swept to power with a two-thirds majority in April 2010. Several of its measures have shocked investors and earned the ire of the European Union.
European Commission President Jose Manuel Barroso asked Orban in a weekend letter to withdraw the central bank bill.
Fidesz has since proposed several amendments to the bill, but has left some contentious parts about the expansion of the Monetary Council intact. Orban has said the government and the central bank must cooperate to provide funding for the economy.
SECOND RATINGS CUT TO JUNK
S&P was the second rating agency within a month, after Moody's, to cut Hungary's debt to below investment grade.
Hungary targets one of the EU's lowest budget deficits next year at 2.5 percent of GDP, but it faces possible recession which poses a risk to the sustainability of its deficit cuts and could jeopardise the government's pledge to reduce debt which at 80 percent of GDP is the highest in central Europe.
Hungary needs to roll over close to 5 billion euros in external debt alone, on top of forint denominated papers, next year.
The country's debt agency said on Thursday its net financing needs for 2012 totalled 674 billion forints and that it would raise 4 billion euros in hard currency debt, either from the market or other sources.
The forint traded at 306.75 to the euro on Thursday morning at 0833 GMT following the downgrade which pushed the currency lower in overseas trade late on Wednesday.
A dealer said investors would likely hold off selling until the new year or until Fitch, the last agency to keep Hungary in investment category, decides to downgrade it as well.
"Investors for now go for the high yield, there is no panic, no selloff," the dealer said.
Hungary's 5-year bonds traded at 9.10 percent on Thursday while the yield on the 10-year benchmark bond was at around 9.12 percent.
"Hungary's economic fundamentals do not justify a junk rating, but the damaging policies of the Hungarian government have undermined investor confidence and this is the key reason why both Moody's and S&P have decided to cut Hungary's rating," Danske Bank said.
"Furthermore, it is clearly worrying that the Hungarian government apparently continues to ignore how negative the consequences of its actions are."
read more: Olympus Wealth Management
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