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Ciaran Kane examines the historical relationship between yields and budget deficits and finds history is unequivocal in linking fiscal deterioration to higher yields.

A key prevailing problem for investment managers and finance directors is to judge the balance of risks between a short term bullish environment and a longer term outlook that is a lot more threatening. In simple terms, the immediate backdrop for financial markets is of a strong global recovery, combined with very benign liquidity conditions. The latter effect stems from extremely low short term interest rates and extensive private sector de-leveraging. Such an environment is bullish from both a growth perspective and from a valuation perspective, as low long term real yields and an investor flight from cash pushes riskier asset (e.g. equity) prices higher. Additionally, de-leveraging narrows credit spreads and eases credit conditions. However, these undeniably and unequivocally constructive near-term conditions, at least so far as liquidity is concerned, are clearly temporary. The medium term outlook, by contrast, is dominated by monetary and fiscal policy risks. The impact of monetary policy changes is well rehearsed and broadly understood. The fiscal situation, however, is comparatively rare and worthy of closer examination.

The broad picture is that many, if not most, G20 economies are in a fiscal mess. This is not a problem merely confined to the southern European nations. The aggregate advanced economy G20 government debt / GDP ratio is projected by the IMF to reach 118% of GDP by 2014. The first point we can make is that such ratios are high enough to provide a significant impediment to growth. Recent research indicates that when debt / GDP ratios are above 90%, the median real growth rate is 1% lower and the average growth rate is 4% lower, compared to when the ratio is below 90%. So there is a basic point to be made, which is that the prevailing fiscal trend points firmly towards a weak medium term growth trend.

The second point we can make is that the long-run fiscal outlook, due to ageing, is extremely poor. In this respect, IMF projections point to advanced G20 government debt / GDP ratios rising by 50 percentage points of GDP over the next two decades due to ageing. The demographics suggest that this effect begins to make its presence felt over the next few years, as the boomer generation starts to retire. The repercussions, therefore, of not reversing the fiscal deterioration generated by the credit crisis are very negative. If debt / GDP ratios are not reduced from current levels over the next several years, demographic trends will drive them to levels that are historically associated with much reduced growth, raising the issue of sustainability.

The third point is that containing the long-term government debt problem is going to be painful. The November 2009 IMF Fiscal Monitor calculates that a return to pre-crisis debt levels would require a 6.5% - 9.2% of GDP swing in advanced G20 economy structural primary budget balances over the next 10 years. The necessary fiscal tightening therefore represents a significant drag on growth. Both the cure and the disease itself will slow growth, the former by significantly less than the latter. Average growth in economies with low debt ratios, such as China, Brazil, Australia and Norway, is going to be much stronger than average growth in the high debt economies, such as Japan, the US, Spain, Greece and the UK.

It is important to bear in mind that the fiscal situation points to a large rise in market interest rates. The historical record is reasonably unambiguous on this score. To quantify this point, we examined the experience of six advanced economies that have experienced large budgetary swings over the past 20-30 years. In all cases, we noted a significant relationship between deficit positions and a change in long term government bond yields - in the order of 31 basis points on average for a 1% shift in deficit / GDP ratios. This is supported by similar research undertaken by the IMF. If we translate that into the real world, and look at the G20 advanced economies in aggregate, the GDP weighted-average change in deficit / GDP ratios is 6.3%, suggesting an upward risk to 10 year government bond yields of just under 200 basis points.

At present, only the Greek government bond market displays a fiscal reaction on the scale described above. The deterioration in the Greek budget deficit / GDP ratio has been around 9.8% of GDP compared to pre-crisis levels. If our formula above is any guide, this deterioration is compatible with a 300bp raise in bond yields. In the event, the spread of Greek 10 year yields to equivalent German bonds is currently about 310bps wider than pre-crisis levels, in line with historical experience. Ominously, it now appears that Spanish and Portuguese yields are starting to display a comparable trend.

The question that begs to be asked is why other fiscal casualties have not experienced a similar rise in bond yields. In our view, the placid behaviour of some of the larger US and UK bond markets is primarily attributable to private sector de-leveraging. With businesses and households paying off debt at a rapid clip, the total net demands on bond markets have declined. Similarly, the negligible level of short term rates is driving investors out of cash instruments and into bonds, again a factor that helps keep real yields low.  Equally, changing regulations and rapidly shrinking loan books have increased the banking system's appetite for high grade bonds. It is reasonable to suppose that the quantitative easing programmes will also have served to dampen the US and UK bond markets' reaction to the fiscal deterioration. Finally, the lack of employment growth in the US is seen by many investors as implying lingering risks of a recessionary relapse, a possibility that props up the appetite for bonds.

However, these conditions are all temporary. At some stage, the various dampening factors currently weighing down bond yields will start to evaporate. At that point, it is inevitable that there will be a large rise in yields. The major risk, therefore, is that there is a form of pent up pressure for much higher yields that is currently being suppressed by temporary factors. The most likely trajectory of developments is that the fiscally induced re-pricing of Greek bonds gradually spreads into other markets, with the trend eventually becoming visible in the UK and US. As with other episodes of markets eventually re-pricing to reflect a clear and long standing fundamental problem, such as the mis-alignment of European exchange rate since the early 1990s and the current account crises across Asia in 1997 - 98, such trends tend to move like an infection, rather than as a single, homogeneous shock. Contagion is therefore the current watchword.

Overall, we can derive several conclusions from this analysis. Firstly, we are "owed" a large rise in bond yields in the high debt / deficit markets. This is not just applicable to Greece, Spain, etc, where it is already happening, but is quite clearly something we need to prepare for in the larger and systemically more important markets in the US and UK.

Secondly, if the deficit trends clearly start to improve, these increases in yield can be reversed. This was most clearly evidenced by the 100bp drop in Irish 10 year yields following the introduction of the recent tough budget. So the second conclusion - which is obvious enough - is that government actions matter a great deal. For the time being, only Ireland has convinced the markets of its seriousness. So far, the pattern is that bond pressures are required to force fiscal restraint.

The third conclusion is that the repair of fiscal positions will take several years to accomplish, implying that risk premia in the high debt / deficit bond markets will be high relative to the low debt / deficit markets for quite a while, albeit declining over time once a convincing fiscal policy is adopted.

The fourth conclusion is that 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 US and UK markets, equities are likely to de-rate and correct strongly. This implies that the current rally simply cannot continue ad infinitum. This is not an argument for a resumption of the bear market, however. The simple picture would be a rise in bond yields, promoting both a correction in equities and a correction to fiscal policies. Once convincing fiscal policies are adopted, risk premia in bond yields will start to decline and equities recover. However, this process is likely to be messy.

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