IndiaratingcutandhistoryofItaliancitystates

The important news of yesterday was the Moody’s rating decision where it downgraded India from the Baa2 to Baa3 with a negative outlook. The current rating is just above investment grade. The news, though sudden, was not entirely surprising as the other rating agencies had already put India on the brink of investment grade some time back and Moody’s was expected to follow suit. As of the market reaction to the announcement, one needs to appreciate the fact that the rating actions are ultimately a lag indicator of the state of underlying assets, the markets in their infinite wisdom already incorporate bad news much in advance. Though a knee jerk reaction can’t be denied.

Rating actions primarily impact the bond markets and, as we know, the bond markets are essentially the bed rock of modern finance as they decide the most fundamental of all parameters: the cost of capital. Bond yields increase with bad news (for example a downgrade). Consequently any government which is running a deficit budget will end up seeing an increase in cost of borrowing for its new issuances, which in turn would impact its decisions on taxation, expenditure etc.

It will be worthwhile to take a slight historical detour here on the evolution of bond markets. Niall Fergusson, the British historian, writes in his book “The Ascent of Money” about the origins of the bond markets. He writes that the Italian city states like Florence, Pisa and Milan invented the concept of bonds around the 13th Century AD. The primary requirement was to finance the incessant wars in which the city states were involved. In the absence of bonds the wars and other expenditures would have been financed by higher taxes. Hence bonds were an amicable arrangement between the city monarchs and the residents to obviate higher taxes. The state got the money and bond investors got a promise of annual returns. Fergusson writes that the most far-sighted innovation of this entire scheme was allowing the secondary market trading of these bonds. The bonds quickly became a liquid, tradeable commodity with concepts like YTM and yield curve emerging shortly afterwards. The bond prices fluctuated with war fortunes with investors celebrating and drowning in equal measure.

In other news, US headlines and President Trump’s tweets are all about the social unrest. Virus news has taken a backseat as of now. As per news reports, some Chinese agri importers will look to stop buying soy and other agriculture produce from the US. Whether this would be in direct contravention of the first phase deal which was signed in January, remains to be seen.

The US stock market closed slightly up. The Dow Jones currently trades at 25475, 4000 points shy from the life-time high seen in mid February. The Dollar Index continues its trend down as the safe haven appeal dwindles and risk on appears to be the prevalent mood. The Euro is trading at 1.1125 currently, having touched a 10 week high of 1.1154 in trading yesterday. Sterling is also trading strong at 1.2490.

In India the markets have shown little reaction to the Moody’s cut. The INR trades at 75.60, 10 year benchmark bond at the yield of 6.06 and the stock markets are trading in slight green. The met department forecasts a normal monsoon this year, which has also added to the positive mood. Monsoon rains are likely to be 102% of LPA with a model error of +-4%.