Four threats government bond markets will face next year

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Investors were hit hard during the euro zone's sovereign debt crisis and when Standard & Poor's cut the U.S. credit rating in 2011. The good news today: Moody's Investors Service believes the outlook for government bonds is looking increasingly stable.

The bad news: Moody's warns of four potential shocks.

The credit rating agency published its 2015 outlook on Tuesday with some upbeat figures: About 80 per cent of rated sovereign bonds have "stable" outlooks, up from 70 per cent at the start of the year and up from just 62 per cent in 2013.

Moody's credits the improvement to a gradual global economic recovery, driven by the United States and China. The U.S. economy is expected to grow by 3 per cent in 2015.

Although China is making headlines for its slowdown, the economy is nonetheless expected to grow between 6.5 per cent and 7.5 per cent. It sees improvements elsewhere, too – most notably in a stronger global-banking system and better government finances.

Even still-troubled Europe gets a shout-out: "In Europe, the diminishing potential for shocks as the financial and debt crises recede, as well as fiscal consolidation and somewhat improved growth prospects have driven the stabilization and, in some cases, the beginnings of a reversal in credit and rating trends," Moody's said in its outlook.

Sure, things could be better than "stable." Just 7 per cent of rated sovereign bonds have "positive" outlooks, compared to 13 per cent with "negative" outlooks. But the bigger worry is among the four potential threats to credit worthiness in the year ahead.

A "disorderly" market reaction after the U.S. Federal Reserve raises its key interest rate

The Fed has telegraphed its intentions for shifting its monetary policy. It succeeded in ending its bond-buying stimulus program without any lasting disruptions, but now faces the task of raising its key interest rate after holding it at about zero per cent throughout the economic recovery.

Moody's already expects that rate increases, starting in mid-2015, will push up global interest rates and hasten the flow of capital to the United States.

The problems start if bond yields rise faster than expected, putting pressure on already-extended government balance sheets, and capital flows reverse sharply. China and South Korea are relatively immune to these issues, but the euro zone and India are vulnerable.

Economic activity gets notably worse in China and the euro zone

In Europe, expectations are already low, with Moody's pencilling in growth of just 1 per cent in 2015, coupled with a persistent threat of deflation.

Moody's is confident that the European Central Bank will do what it can to provide stimulus in the form of quantitative easing, or bond buying.

However, the ECB could face obstacles from countries that don't agree with QE. And in any case, Moody's believes that QE could be less effective in the euro zone than it was in the United States.

In China, the economy's "frailties" can be found in the property, shadow banking and local government sectors, and the fact that they are linked together.

On the upside, Moody's believes that even a so-called hard-landing would knock just two percentage points from the country's gross domestic product.

"Nevertheless, a more severe slowdown in China's economy than we currently expect would have credit implications beyond its borders," Moody's warned.

Geopolitical tensions hit confidence

So far, tensions and outright violence in the world haven't affected many credit ratings – but damage could arise if the various conflicts start to dampen our optimism for a better tomorrow.

"Fears of 'what might happen' deter both domestic and export-oriented companies from investing, and households from consuming," Moody's said.

"Reform fatigue" kicks in

For example, Japan has been implementing a number of changes to its economy and monetary policies over the past year. Yet, the government recently delayed a tax hike and called a snap election to deal with resistance to its reform agenda, illustrating "the tensions inherent in the need to achieve both fiscal consolidation and higher medium-term growth," Moody's said.

So, things look good in 2015 – but don't rest easy.