GOVERNMENT bond yields in developed countries have been steadily falling over the course of 2010 alongside a broad retrenching of risk preferences. Fiscal austerity measures are being implemented across Europe following the emergence of plausible default risk. The cuts planned in most EU countries are being supplemented by concerns that the Chinese economy will tighten monetary policy due to a frothy housing market and rising inflation expectations. The mixture of mushrooming debt in the developed world, draconian spending cuts and emerging markets moving towards policy tightening is having an adverse affect on global asset prices.

The latest retracement from the highs in risk assets is the most significant yet. Investors are retrenching back into cash and safe-havens with the eye-watering declines of 2008 still fresh in their memories. The sovereign debt crisis in Europe has dented recovery expectations the most.

Bond yields and bond spreads can be an excellent indicator of market stress and where the fault lines lie. For example, market participants are keenly watching spreads between peripheral European countries and Germany to see which nation is at most risk of default. Yields on long-term debt in the developed world are falling because investors are insecure about exposing themselves to equities, commodities and risk-FX. The yield on the US two-year government bond has broken below its 2009 lows while US Treasuries have fallen by more than 1 per cent since April. A rising yield spread between German and Spanish debt, for example, indicates that investors perceive Germany to be a safer investment than Spain. The important question is whether investors doubt the solvency of the EU as a whole or whether they don’t believe that Germany will act as a lender of last resort to its neighbours.

The ECB’s bond purchase policy has not calmed the market – yields on on Greek, Portuguese, Spanish and Irish debt remain close to their peaks; so too do CDS prices. Meanwhile, German, Japanese, US and UK bond yields have been falling as demand for the best AAA securities keeps rising.

The implications of this phenomenon are varied. Lower yields would help governments reduce their debt burdens in real terms but to attract investors, austerity measures must be credible and the debt burden cannot be too high to start with. Unfortunately, market prices indicate the measures don’t seem to be credible and the debt burden is extremely high. Arguably, the EU is taking the necessary steps towards fiscal balance but on the other hand, it’s not doing enough because a harmonised fiscal policy is lacking.

The US debt burden is much larger than in Europe but market stress is lower and confidence is higher. California must cut $20bn of expenditure by the end of 2010 – the same as Greece, Portugal and Ireland combined – but traders have yet to question the US budget deficit to the same degree. The coming months are likely to be erratic and volatile while there’s a lack of certainty about how government debt will affect the recovery longer-term.