The Impact of Credit Ratings on the Financial Markets

Standard & Poor’s recent downgrade of Turkey’s credit rating triggered fresh volatility in the country’s financial sector, with stocks and bonds tumbling on fears of further downgrades following President Recep Tayyip Erdogan’s three-month state of emergency. The move came just days after Moody’s Investors Service said it would put the country’s credit rating on review.[1]

The impact of credit ratings on the financial markets is not always easy to understand or predict. Since the fallout of the 2007-2008 subprime mortgage crisis, it became clear that a serious overhaul of the credit rating system was required. The “Big Three” global credit rating agencies – Standard & Poor’s, Moody’s and Fitch Ratings – faced intense scrutiny for their failure to provide reliable information on the level of risk associated with various types of debt.

As a result, the 2010 the Dodd-Frank Wall Street Reform and Consumer Protection Act and 2011 European Securities and Markets Authority have both mandated reforms to hold credit rating agencies accountable. The credit rating agencies themselves have also faced growing legal battles. For Standard & Poor’s, this resulted in a record $1.37 billion settlement in 2015.[2]

The impact of credit ratings on the markets has been studied at length by banks, investors and even governments. The European Central Bank (ECB), for instance, has found that investors typically react to changes in credit ratings if they are unexpected. In this way, credit ratings behave in a similar fashion to other types of new information, such as economic data or corporate earnings that diverge from the consensus forecast.

According to the ECB, bond rating downgrades in particular “percolate from the affected company to its rivals, and from the bond market to equity prices.”

The Bank added, “The price reaction to rating changes, and in particular the effect on stock returns, is asymmetrical. “The market reacts more strongly to rating downgrades than to rating upgrades, and ultimately this asymmetry appears less significant for bonds than for stocks.”[3]

For the country being downgraded, however, the impact appears to be much more direct. In Turkey, a country that relies heavily on external investment, credit downgrades raise fears about a mass exodus of capital that could cripple the country’s ability to rebound.

The market’s response to the Standard & Poor’s downgrade certainly reflected that. The Borsa Istanbul 100 Index fell 4.4% following the downgrade, virtually wiping out the year’s gains. Banking stocks were among the hardest hit, retreating nearly 5% the day following the downgrade. The Turkish lira, which had just set a fresh all-time low, managed to rebound slightly against the US dollar.[4]

The impact of sudden changes to a sovereign’s rating was on full display in 2011 after Standard & Poor’s downgraded the US federal government. It was the first time in 70 years that the US Treasury no longer held a Triple-A credit rating. The downgrade resulted in weeks of massive declines for global equity markets.[5]

The US Treasury example clearly shows that it’s not just countries like Turkey that are at risk of a credit downgrade. Several other sovereigns risk devaluations in the present low-growth environment. The July edition of the International Monetary Fund’s World Economic Outlook pointed to growing uncertainty in the global economy following the United Kingdom’s referendum on European Union (EU) membership. In a post-Brexit world, the United Kingdom’s gross domestic product will expand only 1.3% in 2017, down sharply from the 2.2% growth pace predicted in April.

Growth estimates for advanced industrialized economies as a whole were trimmed to 1.8% in 2016 and 2017, down from 1.9% and 2%, respectively. World output is forecast to grow 3.1% in 2016 and 3.4% in 2017, down from 3.2% and 3.5% previously.[6]

It remains to be seen whether this uncertain environment will result in more vulnerable countries being downgraded to near-junk status.

Credit rating agencies wield tremendous power in the financial markets. Their outlook on a nation’s finances has a direct impact on that country and the global market system that relies on it. It remains to be seen whether the “Big Three” will make their way back into the headlines in the near future as domestic economies struggle for equilibrium.

[1] Constantine Courcoulas and Tugce Ozsoy (July 21, 2016). “Turkey Stocks and Bonds Extend Retreat After S&P’s Rating Cut.” Bloomberg.

[2] Council on Foreign Relations (February 19, 2015). “The Credit Rating Controversy.” Council on Foreign Relations.

[3] David Pett (March 13, 2013). “How credit ratings affect the markets.” Financial Post.

[4] Constantine Courcoulas and Tugce Ozsoy (July 21, 2016). “Turkey Stocks and Bonds Extend Retreat After S&P’s Rating Cut.” Bloomberg.

[5] Damian Paletta and Matt Phillips (August 6, 2016). “S&P Strips U.S. of Top Credit Rating.” The Wall Street Journal.

[6] International Monetary Fund (July 19, 2016). “World Economic Outlook Update: Uncertainty in the Aftermath of the U.K. Referendum.” International Monetary Fund.

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