Markets are bracing for a potentially disastrous new turn in the European debt crisis, as Moody’s rating agency yesterday cut Portugal’s debt rating down four notches, to below-investment status.

Portugal is the latest domino to fall in Europe’s all-consuming debt crisis, which is threatening to trigger the second global financial meltdown in just three years. Europe’s consecutive bailouts of Greece, Ireland and Portugal only appear to be making things worse.

Last week, it was agreed that the EU would muster resources for a second bailout for Greece, although the decision on the bailout was later postponed. But instead of calming markets, as the EU leaders had vainly hoped, the uncertainty surrounding the second bailout only made matters worse.

Rating agency Standard & Poor’s on Monday immediately announced that the conditions of the second bailout, which would involve a voluntary roll-over of some of Greece’s debt by the private sector, would constitute a default.

In another troubling development, the German constitutional court started a hearing on the constitutionality of Germany’s bailout of Greece last year. A far-right member of Merkel’s Conservative bloc in the Bundestag had argued that the Greek bailout constituted an expropriation of German taxpayers and was therefore illegal. If the high court agrees with him, it would throw Europe’s bailout plans of Greece (and other nations) into total disarray.

Moody’s reasoning behind the Portuguese downgrade is that Portugal, like Greece, will not be able to access private capital markets soon enough to finance its expenses, and will therefore require a second bailout, on top of the €78bn emergency loan made earlier this year. This second bailout is likely to take the same shape as Greece’s second bailout, meaning yet another haircut for private lenders.

Meanwhile, the risk of contagion is unlikely to halt in Portugal. As Philip Inman just wrote for the Guardian:

Spain is often talked about as the next domino. On Tuesday ugly economic figures for Italy appeared to put Rome higher up the scale of walking disasters. Unless Brussels admits the full extent of the problems blighting Greece and Portugal, the panic will spread, hurting all of us.

On the Portuguese downgrade, the Guardian reports:

A dangerous new phase in the eurozone crisis opened up on Tuesday after the ratings agency Moody’s downgraded Portugal‘s debt to junk status and said that it would need a second bailout.

As the currency area’s big banks meet in Paris on Wednesday to refine their plans for a second bailout of Greece, Moody’s issued a devastating analysis of Portugal’s finances as it cut the country’s credit rating by four notches, pushing it into junk territory.

The agency said it had rising concerns that Portugal could not fully achieve its budget deficit reduction plans and was facing “formidable challenges in cutting spending, increasing tax compliance, achieving economic growth and supporting its banking system”.

There was an “increasing probability” that Portugal would be unable to borrow at sustainable rates in the market, forcing a bailout on top of the €80bn (£72bn) it accepted from the IMF and EU in April.

The prospect of the continuing problems in Greece spreading to another of the eurozone’s weak economies is a scenario politicians and finance chiefs in Europe have been determined to avoid.

And another Guardian report this morning:

Fears that the eurozone crisis was entering a new stage intensified on Wednesday after Portugal‘s credit rating was slashed to junk, with European bank shares falling sharply and some government bonds coming under renewed pressure.

Portuguese bank shares tumbled in early trading, while the yield – or interest rate – demanded by traders to hold the country’s debt jumped sharply.

Analysis by Phillip Inman here.