Debt fears prompt risk reappraisal

The macroeconomic backdrop has been indeed favorable: global industrial output is booming, U.S. economic growth accelerated in final months of 2009 and central banks are in no rush to tighten their monetary policy. U.S. non-farm payrolls unexpectedly fell in January yet the unemployment rate fell to a five-month low of 9.7 percent.

Group of Seven finance chiefs meeting this weekend in snowy Canada look set to reiterate their promise that substantial stimulus are still needed despite recent strong economic data to maintain the global recovery on track.

However, this also highlights the vulnerability of countries running large public debts, especially in the euro zone, in a move some characterize as “punish the printers”.

What has started as a government debt problem in Greece has now spread to highly-indebted cousins such as Portugal, Spain, sending the cost of insuring these bonds against default to record highs on Friday. The euro hit eight-month troughs against the dollar and world stocks tumbled to three-month lows.

Given that some historical analysis suggest large deficits lead to higher interest rates unrelated to changes in policy rates, investors might be reassessing their 2010 strategy of adding more risky assets.

“Greece is going to be a major issue. It has raised the whole issue of sovereign credit again,” said Jeremy Beckwith, chief investment officer at Kleinwort Benson.

“Everybody has got a recovery printed in for them this year, but they are realizing that we still have secular problems to deal with. In the very short term cash is the only safe place to go. Even government bonds seem to have become more risky because of sovereign risk.”

For Greece, it now costs 444,700 euros per year to insure an exposure of 10 million euros of Greek government bonds, up from 427,000 euros late on Thursday, according to CMA DataVision.

Portuguese 5-year CDS hit a record high of 238 bps from 229.5 bps, while Spanish CDS reached an all-time high of 182 bps from 170 bps. Credit default swaps of other countries such as Austria, Netherlands and Germany suddenly started widening as stress spreads even to safer parts of the 16-nation bloc.

Some bonds have benefiting from a flight to safety, with the two-year German government bonds yield hitting to an all-time low of 0.986 percent. Yields on 10-year and two-year U.S. Treasuries US2YT=RR posted their biggest drop since mid-December on Thursday.

“With strong global liquidity, low inflation and a buoyant inventory cycle driving the market universally into short volatility and long recovery trades since last March, the prospect of re-pricing vulnerable public, financial and private credit risk in open markets, without the hand of central banks, creates the setting for a perfect storm,” said Lena Komileva, head of G7 market economics at TulletPrebon.

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