November 10, 2009 2:00 am

Threat from large budget deficits looms

Government bond yields have been at historic lows this year as extremely easy monetary policy, quantitative easing and an anaemic global outlook have underpinned the market.

However, in recent weeks yields, which have an inverse relationship with prices, have started to tick higher.

Is that simply pricing in economic recovery or does it invite the question, will 2010 be the year of a sovereign debt sell-off?

There is little cause for alarm so far.

However, US Treasury 10-year bond yields have jumped to 3.48 per cent from 3.25 per cent on October 8; German 10-year Bund yields have risen to 3.31 per cent from 3.11 per cent over the same period; UK gilts yields have increased to 3.82 per cent from 3.35 per cent; and Japanese JGB yields have gone up to 1.47 per cent from 1.27 per cent.

The rise in yields has taken place as global economic data has improved. Most notably, US third-quarter gross domestic product came in stronger than expected as the world's biggest economy emerged from its year-long recession.

Only the UK and Spain of the major world economies are still in recession.

The problem is that despite the nascent recovery, central banks are still nervous. Indeed in recent days, they have made it crystal clear that official rates will remain low until they are more confident that the recovery is entrenched.

That has been a boon for equity markets which have rallied on the expectation of a continuation of easy monetary policy, but it has raised concerns about the longer term outlook for inflation.

Don Smith, economist at Icap, says: "The European Central Bank and the Bank of England last week and the G20 over the weekend have sent a strong signal to the markets that rates will remain low."

Two other factors have the potential to send yields higher. They are record levels of government bond supply and governments' ability to reduce their deficits.

So far investors have been relaxed about the bond supply because they have taken the view that governments will eventually address their burgeoning budget deficits. However, were there to be evidence of backsliding on debt reduction, bond markets would quickly sound the alarm.

Some bankers say the government debt problem could be the "big issue" of 2010 in the US, Europe and Japan in the way that it has failed to be this year.

In recent days, the International Monetary Fund and the European Commission have warned that spending cuts and tax increases will be required across the industrialised world to bring public finances under control.

Meanwhile, Wen Jiabao, Chinese premier, has urged the US to restrain its mounting deficit.

"We hope the United States will keep an appropriate size to its deficit so that there will be basic stability in the exchange rate and that it is conducive to stability and the recovery of the global economy," he said on Sunday.

Central bankers are also starting to put pressure on governments to deal with their spiralling public debt.

Following the European Central Bank's rate-setting meeting last week, Jean-Claude Trichet, president, stressed that it was important for governments to begin considering deficit reduction.

One top banker says: "Governments must turn their attention to deficit reduction, or risk jeopardising the economic recovery and prompting a sell-off in the bond markets at the same time."

Richard Batty, investment director of strategy at Standard Life Investments, adds: "The deficits are the next big problem.

"We are getting closer to the point where governments have to start addressing them.

"It could be the big issue of 2010. Without these deficits being reduced, the public finances of certain countries could become unsustainable, which would lead to a very difficult scenario of rising bond yields and weakening currencies."

So far, there have been few signs of difficulties for governments in selling their bonds. Commercial banks, in particular, have shown a healthy appetite for buying sovereign debt.

However, bankers warn that demand for funding could intensify in 2010, amid higher corporate issuance as business activity revives.

The likely withdrawal of quantitative easing in the US and the UK is also likely to push sovereign bond yields higher.

If anything, sovereign bond issuance will be higher in 2010 than it was this year.

Barclays Capital estimates that gross US Treasury coupon issuance will remain higher than $2,000bn from 2010 to 2012.

In the Eurozone, HSBC forecasts issuance will break more records next year, rising to €1,000bn ($1,500), €100bn more than this year and nearly €400bn more than last year.

Moreover, the Japanese government is expected to issue a record Y149,204bn ($1,658bn) in the fiscal year ending March 2010, an 8.2 per cent increase on the previous year.

Mr Smith says: "Governments have issued more bonds than ever. Rising bond yields, which will happen as the economy recovers, will push refinancing costs higher.

"Tackling the record debt levels and deficits could be the next phase of policy focus as the financial crisis subsides."

Yet, in spite of the increasing warnings over public debt and bond supply, actions by regulators and expectations of a slow, drawn-out recovery show a rise in government bond yields is not a given.

Steven Major, head of global fixed income research at HSBC, says: "The regulators are putting pressure on banks to buy government bonds with new rules on liquidity buffers.

This will shore up demand for sovereign debt at a time when the economic recovery is likely to be quite a drawn-out affair, itself a bullish factor for bond investors. Record deficits and bond supply may not prove to be a worry for 2010, while this backdrop of demand remains in place."

However, even Mr Major admits: "In the longer-term governments will need to plan a more sustainable path for public finances."

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