Credit Rating Agencies and their Impact on Forex Trading

What are credit rating agencies?

Credit rating agencies are simply companies that provide objective estimates on how capable a debt issuer (ex. banks, companies, governments) is in fulfilling its debt obligations. Today we usually see these valuations expressed in letters like AAA, BB+, or D.

A lot of major players in the credit rating industry started out by publishing basic information and statistics about stocks and bonds across different industries. Over time, as the amount of information available in markets began to overwhelm individual and institutional investors, a need for cohesive and simplified security analyses emerged.

Who are the major players in the credit rating industry?

Unless you’ve been hibernating in your parents’ basement, you’ll know that Standard & Poor’s, Moody’s and Fitch Ratings are currently the top dogs in the biz. Let’s get to know a little about “The Big Three,” shall we?

Moody’s Corporation started around 1900 when John Moody and his homies published “Moody’s Manual of Industrial and Miscellaneous Securities,” which contains basic information on a wide range of securities. Today, Moody’s Investor Service not only offers information, it also provides research, risk analysis, and credit ratings of over 106,000 structured finance obligations.

Fitch Ratings was founded by John Knowles Fitch in 1913 when he published financial statistics in his “The Fitch Stock and Bond Manual.” In 1924, the Fitch Publishing Company first introduced the “AAA” to “D” ratings scale, which is currently used by the industry. Today, Fitch Ratings provides services from its headquarters in both New York and London and its 51 offices worldwide.

Of course, we can’t forget Standard & Poor’s (S&P)! In 1941 Standard Statistics, publisher of sovereign debt, and bonds ratings, merged with Henry Varnum Poor, publisher of “History of the Railroads and Canals of the United States,” which is one of the first attempts at compiling financial details of the U.S. railroads. Today, S&P is not only known for its ratings, it’s also closely watched for its market indices (ex. S&P 500, S&P/Case-Shiller home price index).

Other budding ratings agencies like DBRS and Egan-Jones have been knocking on the Big Three’s doors since the last financial crisis, but for now, most market analysts still rely on these industry hotshots for information on securities.

How do credit ratings affect forex trading?

Good question, young padawan. Like in any other security, investors look at credit ratings to determine a debt issuer’s ability to repay a loan. In forex trading, credit ratings mostly apply to sovereign debts, or bonds issued by governments to finance economic growth.

Since sovereign debts are usually denominated in foreign currencies, countries with unstable exchange rates or low economic growth usually have low credit ratings since they present additional risk of not being able to pay back their investors. As a result, countries with low credit ratings usually have to pay more than its high-rating counterparts in order to borrow the same amount of money from markets.

In the euro zone‘s case, credit ratings are also used to determine sizes of bailout packages. After S&P downgraded the EFSF‘s rating from AAA a couple of days ago, market players have been buzzing for a need for Germany, the biggest of the four AAA-rated euro zone economies, to boost its contribution in order for the EFSF to maintain its lending capacity of 440 billion EUR.

Do credit rating decisions directly affect my favorite currency pairs?

Since credit ratings factor greatly in investors’ analyses, any major announcement from the Big Three ratings agencies have the potential to directly affect your currency trades.

S&P

Heck, you don’t even have to look far for an example. As I pointed out in my 2011 year-end special articles, S&P caused quite a ruckus on EUR/USD and the other major currency pairs when it downgraded U.S. debt for the first time in history. In fact, the same ratings agency also inspired a broad selloff in risk a couple of days ago when it downgraded credit ratings of nine euro zone member states!

Fitch and Moody’s recently reaffirmed their estimates, but many believe that it’s only a matter of time before they follow suit and start downgrading a few euro zone states as well.

Now that you know the importance of these credit rating agencies, you must remember that they’re not the be-all and end-all in market valuations. The fact that not all credit ratings agencies are in sync with their assessment suggests that no single ratings agency, maybe not even the combination of the Big Three, can present the whole picture when it comes to analyzing sovereign debts. There are too many factors to consider, after all. Hey, you must do your homework too!

  • Mike Dever

    Although the credit rating agencies do have short-term impacts on the currency pairs, their ratings are redundant at best. That is because the markets already set the credit worthiness of any borrower that has outstanding paper. The price is out there. The price of credit default swaps is out there. That is the ‘real’ credit rating of a sovereign or corporate borrower. Ratings are both redundant and dumber than the crowd-sourced price that already exists.

    I talk about the failure of the credit rating agencies and government regulations in my book “Jackass Investing.” I’m pleased to provide readers with a complimentary link to the two chapters dealing with this (Myth #13: It’s Best to Follow Expert Advice and Myth #14: Government Regulations Protect investors):

    link to jackassinvesting.com

    link to jackassinvesting.com

    Mike Dever
    Author, Jackass Investing: Don’t do it. Profit from it.