Description
Credit Rating Agencies (CRAs) are widely held to be powerful institutions at the heart of contemporary financial markets. Here, I extend understanding of the foundations of CRA power by developing a model of financial market psychology under conditions of policy uncertainty. I posit that when economic policy uncertainty is high, unpredictability generates fear amongst market participants, with fear in turn causing amplified responses to market signals. Under the influence of this psychological nexus, we expect to see stronger market response to CRA bond downgrades when economic policy uncertainty is high. I confirm the existence of this ‘policy uncertainty premium’ on CRA power in the US corporate bond market; when economic policy uncertainty is high, the impact of a rating downgrade on a bond spread rises from around 4 to around 9 basis points. Policy uncertainty, it seems, leads to amplified responses to credit rating downgrades.
