By Natsuko Waki
LONDON, Feb 5 (Reuters) - Hurdles blocking what could be a long cyclical rally in risky assets based on ample liquidity are proving higher than investors had anticipated with the escalating euro zone debt crisis prompting a reappraisal.
The macroeconomic backdrop has been indeed favourable: 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 characterise 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 realising 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.
UPWARD RATES RISK
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 annualised 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 has with 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."
(Editing by Ron Askew)