Saturday, July 13, 2013

Fitch downgrades France: how credit rating changes impacts the markets

France will celebrate Bastille day with a bad news, Fitch Ratings joined S&P and Moody’s in stripping France of its AAA credit rating.

Ratings agency Fitch downgraded France from the top AAA credit rating on Friday, citing a heavier government debt load and poor prospects for growth.

In slashing France's rating to 'AA +', Fitch became the last of the big three credit raters to knock France off the top perch. Last year Standard & Poor's and Moody's already downgraded France from the AAA club.

Fitch, which is part French owned, had warned in its previous appraisal that France had reached the very limit of being able to hold on to its top grade grail.

But with Fitch now expecting public debt to peak next year at 96 percent of gross domestic product, the agency said it had no choice but to lower the mark, though with a stable outlook.
I think that France deserves more, or that the present downgrades may just be the start of the string of downgrades that France will be faced with.

But the actions of the credit rating agencies gives some very important insights, particularly on the effects of re-ratings on the marketplace.


Contra to the mainstream intuition that downside re-ratings of debt should translate to higher interest rates as default risk premium should rise, the S&P and Moody’s actions in 2012, particularly in January and November, respectively, came in backdrop of the opposite direction:a colossal rally 10 year bonds expressed via sharply lower yields. 

So the French government can easily issue a rejoinder to these credit rating agencies saying “you fools, the market says you are wrong!”

But of course, this has not been simple. 

Part of that rally has been due to the series of credit easing policies by the ECB since the financial crisis of 2007, and, more importantly, the  ECB’s implicit backstop. ECB’s Mario Draghi unveiled the details of the bond buying scheme via outright monetary transactions, or OMTs last September.


The US Federal Reserve has also reportedly injected over $1 trillion in cash to European banks with US operations. Such funds may have also been used to buy government European debt too.

Other factors as such as changes in reserve requirement could have also contributed to bond boom. Fund manager Charles Gave of Gavekal Research recently wrote: (bold original)
Knowing this, why then are French rates so low? The usual explanations (purchases by the Swiss National Bank and Mrs. Watanabe buying) have some merit, but other factors may also be at play. France has a large financial sector, with huge international positions. Some entities may be selling international holdings which demand large reserve requirements. The proceeds are then brought back in France to buy French government bonds—against which there are no reserve requirements.

The economic impact of such a trend would indeed be benign for interest rates. But ultimately, it raises the risk on the French financial balance sheet: less diversity, and more vulnerability to a problem with the local sovereign.
In short, there has been a lot of moving parts, mostly political interventions, that has led to the bond rally.


The popular wisdom is that upgrades and downgrades impact the equity markets where upgrades lifts the markets while downgrades should do the opposite.

Well in the French case, this simply has not been true.

And as I previously pointed out, French markets and the economy has gone in antipodal directions and thus a parallel universe. Sporadic recessions through 2012 hasn’t stopped the French equity benchmark the CAC 40 from booming.

France has seen booming bond markets and stock markets amidst intermittent recession and credit rating downgrades—all contradictory to mainstream wisdom.

Of course, all these have operated on the backdrop of an easy money landscape which is about to change.  The developing “head and shoulders” formation in the CAC 40 could serve as clue.

The lesson here is that the credit rating upgrades or downgrades have little relationship with market actions. And for those in the mainstream who tout these to justify a bias, they are most likely to be misguided and wrong.

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