Has Moodys downgrade of France confused bond yields with creditworthiness and risk?

Yesterday gave an interesting example of market behaviour. After a series of falls we saw equity markets surge in a pattern which usually defines a bear market rally. My metaphor for such an event is a summer shower of rain which may be heavy at the time but within a few hours there is often no evidence of its existence. No rule of thumb works every time but a 207 point rally in the US Dow Jones Industrial Average to 12,796 certainly fulfills part of the criteria. I found it particularly fascinating to watch the equity market in my subject of the day Italy surge by 3% as measured by the FTSE:MIB index on a day where she had produced poor industrial turnover and new orders numbers.

I have to say that I found the fact that we saw such surges followed later by a downgrade of France by Moodys (from Aaa to Aa1) particularly fascinating. After all the nation itself is informed of such ratings moves twenty-four hours before. I would imagine that I am not the only person wondering if the aggressive headling about France in the latest Economist magazine was influenced by some form of what is called “the early wire”?

What did Moodys say?

I covered the position of the French economy myself on the 9th of November and will discuss here only new thoughts. Mind you I do find the first point a combination of bizarre and maybe a perversion of the role of a ratings agency so let’s get straight to it!

A rise in debt service costs would further increase the pressure on the finances of the French government, which, unlike other non-euro area sovereigns that carry similarly high ratings, does not have access to a national central bank that could assist with the financing of its debt in the event of a market disruption.

The section that I have highlighted is a description of Quantitative Easing where a central bank buys the debt of its own country in return for providing the previous owners with what in effect is newly minted cash albeit of the electronic variety.

Are Moodys correct with this bit?

No.

In my opinion Moodys are confusing credit risk with bond yields. In general the use of QE tends to reduce a country’s government bond yields but this is by no means the same as reducing the risk overall. There is a gain from it in terms of reducing debt financing costs as the recent shenanigans between the Bank of England and the UK Treasury have highlighted. However there are also costs in terms of inflation, feeding the too big to fail strategy and thereby stopping what is called “creative destruction” and the exchange rate. Ratings agencies should reflect risks rather than only prices and yields and Moodys have failed to do this here.

So we see risk as measured by a rating agency diverge substantially from credit worthiness in a repeat of the way they helped plunge us into the credit crunch by mispricing mortgage-backed securities. I suppose you could say that they are being consistent except that in this instance I do not mean it as a compliment, quite the reverse!

Emergency Liquidity Assistance

This is something available to the Bank of France although to do it then it theoretically requires the permission of the European Central Bank. I say theoretically because I have wondered if some of the users of ELA such as Greece and Ireland have in effect “bounced” the ECB into agreement. Whilst it is not QE it is something which in effect has quite a few similarities to it as a central bank takes assets (bonds) in return for freshly created cash. The assets are collateral -usually at the dodgy end of the spectrum- rather than being purchased but if you think about it there are quite a few scenarios where the central bank ends up with them. If we apply the sovereign-bank loop to this we see that whilst it is not the same it may well turn out to be  to use one of the buzz-words of recent years fungible in its concept.

How much impact has the downgrade had?

One of the regular themes of this blog is that these downgrades have lost their impact on financial markets. We are seeing an illustration of this so far today as the French ten-year government bond yield has risen by only 0.03% to 2.1% and 2.1% is hardly a threatening yield is it? It is in fact not far from the lowest it has been in recent memory and the Euro era. The main French equity index the CAC 40 is down some 11 points at 3428 and when we consider that it too rallied nearly 3% yesterday we see the scale of the (non) response so far.

The oil price

Today’s topics are somewhat entwined as France is one of the countries most hurt by a rising oil price as she is not a producer of it on any but a minor scale and is 71st on a list of oil reserves by country. Yesterday’s equity market surge was accompanied by a surge in the oil price as  what is called a “risk-on” day also had the political/war issues of what is currently happening in Israel/Palestine added to it.

The price of a barrel of Brent Crude Oil is above US $111 again but because on Friday the futures market switched from December to January it looked as though it lost three dollars when it did not! However even so it is now some 3% higher than it was at this point in 2011. So just when many economies least need it we are seeing a rising oil price which has both inflationary-via its role as a fuel and also input in many types of production- and deflationary -in a relatively cash-strapped era spending more on it means that other spending is likely to be cut-. Oil producing countries at least have the extra revenue but countries like France do not even have that as a counterbalance.

West Texas Intermediate

This has been rising too recently but it’s behaviour has over the past year illustrated one of the themes with which I started this blog. This was that in many ways it is getting ever harder to know what prices are as we face so many different tariffs which are designed to confuse. But with the oil price we have the issue that the price of West Texas Intermediate has fallen by 9% over the past year compared to the 3% rise for Brent Crude.

So as European and other readers frown American readers can permit themselves a smile! If we consider the theory the way that WTI has behaved should be the reality in a weakening world economy but we also know that these days theory and reality are like friends who meet infrequently.

Exchange Rates

Whilst there are challenges to it these days the oil price is still pretty much in US dollars so for most the exchange rate with it matters. For UK readers you can relax a little as a year ago we were here. Actually I exaggerate slightly as we have moved from 1.58 to 1.59 and a bit! However the Euro has dropped by 5% so oil costs in it will be driven up by that amount too. Even something which will be welcomed by many Euro nations has a drawback at times and in a way that is another theme of the credit crunch era.

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9 thoughts on “Has Moodys downgrade of France confused bond yields with creditworthiness and risk?

  1. Hi Shaun,

    the lack of market response to the French downgrade shows just how little credibility and influence the ratings agencies have. They were wrong on MBS and have frequently been behind the curve.

    I’m also curious to see how France’s tax raising experiment affects it’s tax revenue, with various high profile departures including Gerald Depardieu moving to Belgium.

    • Hi Expat

      If we record the moves on the day then the Euro is at US $1.28 so no real impact there and the CAC 40 equity index rose 20 points to 3450 so no signs there either. Moodys could make a claim for influencing French government bond prices as the ten-year yield rose by 0.07% to 2.15%, but against that bond prices fell more generally today with UK and German yields also rising.

  2. Shaun,
    Very interesting as always. The Economist article (I read the whole thing) has some amazing stats about how anti-business France is. In fact, you can hardly believe that anyone sets up there, with the NI equivalent at 30%, impossibility of firing anyone etc etc.
    And then you look at the terrible move in the terms of trade against Germany since the Euro fixed the exchange rate, add the madness of DEcreasing the retirement age and increasing taxes and you cannot help feeling that (as the economist rather concludes) that something is going to snap here and France will look like its southern neighbours…

    • James
      I posted the stats on new French Company formation last week, I hope you dont mind me repeating them.
      ‘The Economist articles on France were predictable.
      Country of contadictions is France, more Fortune 500 company HQs in Paris than any other city in the world except NY. More than 50K new companies created in October, over 500k in 2012 to date.’
      France appears to be high cost and beaurocratic to the ‘anglo’ looking in. But their ‘auto-entrepreneur’ arrangement , for instance, allows a new business to be created on-line in literally minutes with advantageous tax and social charges. I find France a country of almost endless contradictions. ‘My part’ of France near the Swiss border feels economically like Surrey with mountains, or perhaps Munich might be a better comparison.

  3. Hi Shaun
    Yes I totally agree the downgrade seems purely predicated on France’s CB inability to print its own money. I think I am correct in saying that if you follow this ‘logic’ through it is Germany that should suffer the greatest downgrade as ultimately it holds the greatest risk in the EZ transfer mechanism.
    Perhaps no-one takes any notice of Moodys et al anymore?

    • Hi JW

      Sometimes the ratings agencies write a good report but invariably they are a long way behind the curve. Moodys tried to look forwards with last nights move on France but the inability to use QE is shared by 16 others where you could have some fun deciding who should have shared her fate.

      Also the sword of Damocles will fall on the UK sooner or later. The whole issue is so politicised that I wonder if it too will be presented as a “surprise”

  4. Shaun

    Your point about 5% drop in Euro pushing up oil prices by that amount too…..

    I think this is one of many reasons why energy & mineral poor European countries can’t devalue their way out of this mess – that is if the goal is to shift to manufacturing and export your way to growth.

    Quite simply manufacturing takes inputs of raw materials & energy – then uses human labour and human expertise to convert them to saleable products. If the energy & raw materials are imported then your only competitive advantage is labour cost or expertise. I don’t see how we in the west can compete on labour cost so its going to have to be the latter. Sadly I think 30 years of unbalancing the economy towards services has seriously damaged our technological and skills advantage. Although I sometimes hear the argument that we do the high value end of the supply chain e.g. Apple – whilst the Chinese do the manual labour. I think this is ludicrously naive and frankly insulting – not dis-similar to arguments used to dismiss Japanese competition 30+ years ago,

    Then of course we can deploy robotics – not withstanding the fact that the UK has little expertise in this area unlike Switzerland (a world leader in the field). However we are a bit behind here

    “The International Federation of Robotics (IFR) said back in August that China had quadrupled its annual supply of industrial robots between 2006-2011, and now sits just ahead of the US but behind Korea and Japan.”

    The future growth areas might be in assembly plants – assembling foreign made components – this tends to work best where the volume of the finished article is much greater than the volume of the components e.g. cars – so the increased UK labour cost if offset by reduced shipping cost.

    But otherwise I find it very hard to see how currency devaluation leads to significant manufacturing growth in a high labour cost Western economy – not unless the devaluation pushes labour cost below the $20 a level which I would suggest implies anarchy.

    However its easy to see that it will cause inflation and falling living standards…..

    Anyway we’ve had a little taster of Sterling depreciation with no visible gain – there will be plenty more to come, so I think this is one of area of debate where we will get to witness the outcome.

    • Hi Dave

      There are problems with a strategy based on devaluation/depreciation with the main one being as you say a rise in input costs. However there are gains for countries in terms of their trade balance which can give a boost and several of the countries in trouble in the Euro area have improved their trade balance in the crisis.

      If we look at Greece then the Bank of Greece released these numbers yesterday

      “In the January-September 2012 period, the current account deficit contracted by €11.3 billion or 76.5% year-on-year, to €3.5 billion. ”

      Now much of this is import substitution/collapse but there has also been an export improvement and this is also true of Portugal in 2012. In this instance they may well be in a better place than us because whilst we did improve after the 2007/08 depreciation of £ it was by a disappointing amount as we got inflation too.

      There is no magic answer to any of these issues but the combination of the right policies can work as opposed to the current repetition of failure.

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