Ratings agencies like to be the bearers of bad news, but should we listen?

Markets panicked when the US economy was given a black mark recently, but they soon bounced back.

Valentine's Day 2002 is seared on my memory. But not because I received roses and a note in an unknown hand. I'll remember it because, just as I was tidying my desk and preparing to go to meet my girlfriend, the fund I was working for was put on "credit watch negative" by Fitch, one of the rating agencies. For an investment firm that relied on its AAA rating from all three agencies (the other two are Standard and Poor's - S&P - and Moody's), it spelled catastrophe. I made an apologetic phone call to my girlfriend and sat back to watch the carnage unfold.

Even though the ratings agencies had recently had their reputations damaged by of their reluctance to downgrade Enron when it was clear that the company was heading for default, they still wielded huge power. The chief exe­cutive's telephone began to trill as the press got wind of Fitch's move. I, a lowly analyst, couldn't do much, so I sat and watched on my Bloomberg screen as the fund's credit spreads (the cost of borrowing on the market) rose gradually and then, as the story began to break across the newswires, spiked.

Playground spat

The reason for Fitch's action was highly technical and, we believed, entirely specious - it was referred to in the financial press at the time as
a "playground spat". Nonetheless, it looked like the agency - the smallest of the three - was going to bring down a $32bn fund. I sat at my desk until midnight, surveying the wreckage of my embryonic career. Fitch reversed its credit watch less than a month later, but it remained a lesson in the power of the unregulated rating agencies.

The "negative outlook" that S&P attached to the US government's AAA rating on 18 April was less dramatic than a full-blown credit watch negative. The latter highlights the imminent risk of a ratings downgrade; a negative outlook merely points to a potential shift in the rating over a two-year period if a company or country continues on its current path. The markets didn't treat the news as if it wasn't of much importance, though.

Gold surged $14 an ounce in ten minutes to reach an all-time high of $1,497.20. The Dow Jones Index dropped 200 points, and the FTSE, having climbed above the magic 6,000 level before news of S&P's move broke, fell back to 5,870. US government treasuries, usually a safe haven in times of turmoil, also slumped.

Analysts and the press scratched their heads and asked why the move had prompted such a sudden sell-off. Surely the rating agencies had lost their power to influence global markets following their shameful part in the "ratings inflation" that played such a crucial role in the sub-prime mess? It did seem bizarre that what looked like another playground spat had wiped billions off the value of international markets.

The negative outlook was implemented by S&P's Toronto-based analyst Nikola Swann ­after she noted an "increased risk" that there would be no resolution to "the medium- and long-term fiscal challenges" facing the US until after the 2012 elections. Net US government debt stands at 75 per cent of gross domestic product and, in Swann's scenario, it will rise to 84 per cent by 2013. Although it was never explicitly identified as such, an important influence on S&P's move was the publication, on 13 April, of the Democratic and Republican deficit reduction plans. The two big parties are some way from reaching agreement on the appropriate spilt between spending cuts and tax rises. Swann's analysis hangs over the negotiators like a guillotine blade as they attempt to thrash out a deal.

It all sounds very familiar. In May 2009, S&P put the UK's AAA rating on negative outlook, citing a worsening deficit and the lack of credible government plans to tackle it. When George Osborne's monomaniacal focus on spending cuts revealed itself, and it became obvious that deficit reduction was at the forefront of the coalition government's economic plans, S&P removed the negative outlook.

Highs and lows

When traders realised that S&P's move on the US rating was merely an effect of political horse-trading, the markets bounced back aggressively. It has become a recognisable pattern. Hedge funds, particularly the high-frequency momentum traders who furiously reposition their portfolios to capture minute market moves, behave in a highly volatile way whenever bad news is announced. As the news breaks there is a sharp sell-off and then, once it becomes clear that the world isn't ending, comes an equally frantic bounce.

By the close of business in the US on 18 April, markets had retreated from their lows and they rallied strongly over the next several days. The FTSE burst back through the 6,000 level and gold receded from its highs. The markets realised that the US, as the issuer of the global reserve currency of choice, has a huge amount of freedom in managing its deficit, that it is likely that Barack Obama will compromise with the Republicans and that even a downgrade would not be a disaster. In the past 20 years, Canada, France, Sweden and Denmark have all lost and then regained their AAA ratings with no long-term negative effects.

Naturally, it could be that S&P is just playing catch-up. Last November, Dagong, China's first domestic rating agency, downgraded US government debt. "The serious defects in the US economy will lead to long-term recession and fundamentally lower the national solvency," Dagong said in a report. Not wishing to leave the readership in any doubt, the accompanying press release ended with the warning that US "solvency is on the brink of collapse". But who listens to rating agencies anyway?

Alex Preston's novel "This Bleeding City" is published by Faber & Faber (£7.99). His City and Finance column runs fortnightly.

This article first appeared in the 02 May 2011 issue of the New Statesman, The Firm