Debt fears prompt risk reappraisal

Without even central banks raising interest rates, there might be upward pressure on yields from ballooning government deficits.

Barclays Capital, which examined the experience of six advanced economies that have experienced large budgetary swings over the past 20-30 years, found a significant relationship between deficit positions and the change in bond yields that was not caused by or related to change in policy rates.

The impact of a one percent change in deficit/GDP ratios on bond yields averaged 31 bps.

Currently the 5-year compound annualized growth rate for the U.S. government debt/GDP ratio stands at 6.4 percent, suggesting there is a 250 bps upward risk for a measure of inflation expectations for five years from now over the following five years. The 10-year yields have an upward risk of 224 bps.

For G20 advanced economies in aggregate, yields have an upward risk of just under 200 bps.

“The historical odds do very much weigh on the side of this rise in yields occurring, which tends to suggest that we should determine our investments with the view that a large rise in government bond yields is not so much a risk, as an absolute inevitability,” Tim Bond, head of asset allocation at Barclays, said in a note to clients.

Bond said the fiscally induced re-pricing of Greek bonds could gradually spread into other markets, with the trend eventually become visible in gilts and treasuries markets.

“The prospects for equities have deteriorated abruptly, given the upward risks to bond yields. If the rise in southern European government bond yields shows signs of infecting gilt and treasury yields, equities are likely to de-rate and correct strongly,” he said.

“This implies that the current rally simply cannot be extrapolated ad infinitum.”

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