What is the role of a rating's agency?

Today S&P (The ratings agency) put 15 Eurozone countries on negative credit watch. Friday, December 9th we are looking to hear what the EU summit comes up with as far as plans to fix the Eurozone. A friend of mine suggested that perhaps this was their way of putting pressure on the EU to make sure that it comes out with something concrete on Friday. While such a pro-active stance in the markets is probably not what ratings agencies are for, it seems to be the only thing that could've possibly prompted such a negative outlook. It is not as if there is new information that S&P has provided that changes the picture in Europe. Nothing is any different today than it was yesterday, so this negative outlook might as well have been made weeks ago. Without any materially new information, one has to scratch their head and wonder if there is any reason to pay any attention to the reminder of already-known information.

Unfortunately, part of the reason we have to pay attention to the news is that funds have mandates about the types of securities they can invest in according to the ratings that S&P among others put out. For instance, wealth managers might have an agreement with conservative investors that they will only invest in AAA rated securities. If a security that once had a AAA rating is downgraded, the portfolio manager may be forced to sell out. So it is a self-fulfilling prophecy. Now, while we can only hope that any PM managing a conservative portfolio has steered far clear from Euro sovereign debt (because it is not conservative regardless of rating) the fact that Rating Agencies' ratings are used as a barometer for eligible securities in a portfolio requires that we at least open our ears when they talk. The S&P dropped about 14 handles peak to trough after the news, but closed the day higher. Still, we did not manage to close above the 200 DMA on the S&P, though we did hit it intra-day.

While I tend to focus on my negativity toward Europe, it is important to note that there has been a real shift in sentiment towards the sovereign crisis. We are certainly not out of the woods, but there has been, starting late last week, a rally in the Euro sovereign bonds. I have mentioned previously that while equity markets have rallied, the Euro sovereign debt continued to drop. The debt generally tells the more important story as stocks can rise in an inflationary environment even if the economic backdrop is ugly. We have seen a rally in both bond and equity markets, indicating there is some actual positive (or better put less negative) sentiment surrounding Europe right now.