Yesterday I discussed how credit rating agencies work and why they are a healthy part of a mature bonds market. To recap: credit rating agencies like Moody’s, Fitch, and S&P rate the creditworthiness of nations based on economic and political indicators, and publish those ratings to investors. Investors in turn pay for these in-depth credit ratings to decide exactly what bonds they should invest in and how much. Investors are willing to invest in lower credit-worthy bonds, but will only do so if they can get a higher interest rate due to the higher risk involved. That’s why it is big news when a ratings agency cuts their rating of a country’s bonds, such as Italy. This should directly translate into the market seeing Italy as a riskier investment and thus demanding higher interest rate to buy Italian bonds, forcing the Italian government to spend more and more money servicing its debt and deficit.

That’s the simple part but it doesn’t always work like that. Here for instance is the “spread” between Italian bonds and German bonds, it can be seen as how much more Italy has to spend to service its debt than Germany does. Germany’s bonds did not have any cut in outlook so they should be fairly stable, while Italy’s outlook was cut so it should have even more expensive bonds, right? Well not in this case, Italy’s outlook was cut on August 5th and since then Italy’s borrowing costs have gone down relative to Germany’s. Now I don’t want to ascribe too much to any one thing, analysts have a tendency to over-analyze market moves, but there is a sort of pattern that is often called “buy the rumor, sell the news.” In this case, investors expected Italy’s credit outlook to be cut, so they expected Italy’s bonds to get more expensive. They thus invested in such a way that the price of Italian borrowing went up prior to the actual cut, and then went down after it happened. Regardless, even with this messy pattern it’s hard to say that Moody’s alone was responsible for any increase in Italian borrowing cost, there’s clearly more to it than that.

And that’s an important caveat to the bond markets, Information from Moody’s and other ratings agencies are of course used by investors to inform their decisions, but they aren’t the only thing used. Indeed, Moody’s can sometimes seem reactive rather than proactive, it cuts a country’s credit rating after the country’s borrowing cost has already gone way up due to other economic or political news. Moody’s and the credit agencies are I think a big easy target for financially illiterate commentators because they’re easy to blame. The big bad American ratings agencies cut our credit score and made it more expensive for us to borrow. But these agencies are just one cog in the much larger bond market, and the individual actions of thousands of investors big and small is what causes the change in borrowing costs. If no one trusted Moody’s they wouldn’t have any effect on the bond market, and if they weren’t seen as trustworthy raters of bonds then no one would trust them. But Moody’s doesn’t have the kind of power and authority that its detractors ascribe to it, and Italy’s borrowing costs are expensive for many, many reasons that would not be fixed by Moody’s giving them an Aaa credit rating.