The G20 meeting in Toronto brought a slight victory for bond owners as governments agreed the obvious – current deficit levels are unsustainable.

The meeting asked all countries to follow “growth-friendly fiscal consolidation plans”, which is a perfectly impossible. The plan is to halve deficits by 2013 and stabilize the ratio of debt to gross domestic product by 2016. However each country may address its deficits at a speed of its own liking, and there will be no formal sanctions for governments breaking the deficit pledge. In plain English: everybody does whatever he wants.

It could have been worse (for bond investors) – the biggest fear being another huge program of quantitative easing in the US. It might be unavoidable anyway.

Usually governments like to spend their way out of a recession. But debt and deficit levels have reached such enormous proportions that many have found themselves at a dead end. Bond markets are not willing to sponsor the financially irresponsible indefinitely. Once a point of no return is reached the music just stops.

Fiscal austerity leads short-term to lower growth, hence is negative for stocks. On Monday however European stock markets were up by 1.5% (and US markets more or less flat). While US 10yr government bond yields reached the lowest level in over a year the stock market ignores these signals. A long-term comparison suggests the stock market, which is often lagging the bond market, has the potential to drop by roughly 20%:

Source: StockCharts.com