Markets Unfazed by Moody's Six European Downgrades

Credit ratings agencies lag markets, but their opinions still matter

By SHARE

Ratings agency Moody's downgraded the credit ratings for six European nations Monday, including Italy and Spain, also changing the outlook to "negative" for Austria, France and the U.K. Despite this high-profile acknowledgement of the euro area's fiscal problems, the market response has been muted.

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In a statement about the downgrades, Moody's cited "uncertainty" over the euro zone's prospects for fiscal and economic reform, as well as "Europe's increasingly weak macroeconomic prospects." However, borrowing costs remained largely unchanged for the downgraded countries. In addition, Italy was still able to auction off nearly $8 billion in debt Tuesday, showing that there is still plenty of demand for Italian bonds.

"The market expected this, and is not treating this as anything new per se," says Anthony Valeri, a fixed income strategist at LPL Financial, a financial services firm based in San Diego, Calif."A successful Italian bond auction is an indication the market is largely ignoring this news."

Credit ratings agencies serve an important purpose in the financial world, providing a shorthand estimate of the creditworthiness of debt issuers, like countries and corporations. A rating provides an independent estimate of risk to investors and issuers alike.

However, recent experience suggests that the ratings agencies are following-rather than dictating-how investors view Europe's sovereign debt risk. Markets were calm after S&P's own January downgrade of nine European nations. Despite widespread hand-wringing, Standard & Poor's unprecedented downgrade of U.S. credit last year did not push U.S. borrowing costs upward.

"Bond markets in general realize that the rating agencies are a lagging indicator. Markets usually have priced that in,"says Valeri. Especially in Europe's case, he adds, investors often look to more real-time indicators of risk, like prices on credit default swaps—an instrument whose price depends upon whether a debtor appears more or less likely to default. The price of Greek credit default swaps, for example, has skyrocketed over the past year.

So if ratings agencies are slow to downgrade sovereign debt, and markets anticipate their moves anyway, do the opinions of institutions like S&P and Moody's still matter?

Ultimately they do, because downgrades are felt in areas outside the bond market, says Valeri. "There's also potential ramifications for countries' banking systems. S&P kind of links sovereign rating with banks in that particular country," he says.

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For example, following an S&P downgrade of Italian and Spanish debt last month, that agency also just downgraded 34 of Italy's financial institutions, as well as 15 Spanish banks. Government debt downgrades can hurt domestic banks that hold large quantities of those bonds.

"We anticipate persistently weak profitability for Italian banks in the next few years," said S&P in a statement, as reported by Reuters.

In addition, for highly-rated countries, a downgrade can be particularly harmful. Valeri points to Germany, which still retains top-notch credit ratings from S&P and Moody's alike, and France, which lost its S&P triple-A rating last month when it was downgraded to AA+. Moody's also has now changed the outlook on France's triple-A rating to negative. A downgrade for countries that look risk-free can be a major blow to outside investment.

Though the world knows that Euro zone countries are, as a whole, facing massive fiscal challenges, Greece remains the focus of attention. The nation just passed austerity measures as a condition of receiving another E.U. bailout, but that is just one step in a long and painful process. Greece must still go through the difficult process of implementing those measures, as well as dealing with its long-term debt problems.

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