Contemplating the sustainability the recent powerful rally in the government bond markets raises many troubling questions. This is particularly the case in the US, where bond yields have fallen to their lowest levels in over 40 years at the same time that fiscal and monetary policy makers have shifted into overdrive in their bid to reflate economic growth. It also comes at a time where the dollar has fallen to its lowest levels in four years and looks likely to go significantly lower given the widening current account deficit.

The recent rally has seen 10-year bond yields plunge from 4.00 percent to 3.12 percent in the space of six weeks.

The catalyst for this explosive rally was a series of uncharacteristically blunt statements on the threat of deflation from the usually obtuse Federal Reserve chairman, Alan Greenspan. Investors interpreted Mr. Greenspan's dire assessment about deflation to mean that the Federal Reserve, much like the Bank of Japan, was ready to buy longer dated bonds as another ploy to lower interest rates and inject more money into the system. It was one of the most blatant attempts by the usually conservative chairman to manipulate the market and in the short term at least, it seems to have worked. The decline in 10-year yields has been a boon for both potential and current home-owners, with the recent wave of re-financing hitting record levels. There is some question as to whether this money will materialise in stronger consumer demand, however.

This week, global bond yields have weathered a sharp correction and the yield on the US ten-year note this week has jumped back to 3.38 percent by the close of trading on Friday. This may have partly been due to concerns that the Federal Reserve would now only cut US interest rates 25 basis points at its Federal Open Market Committee meeting on June 25, because the current economic recovery still has potential to gather momentum later in the year. A distinction however must be made here. Short-term volatility is one thing, the obfuscation of the bond market's valuation caused by the Fed's recent "Open Mouth" policy is something quite different altogether.

To be sure, deflationary pressures do exist, although perhaps not to the extent that has gripped the market in this vice of fear. So while the Fed has hinted it is prepared to tolerate a little inflation to boost pricing power, it is no surprise that they do not appear in a great hurry to buy bonds in the open market as they hinted in April. Furthermore, it seems the market may also be very wrong as to what part of the Treasury curve the Fed would buy if the need arose.

As Thomas Sowanick, Merrill Lynch's Chief Global Fixed Income Strategist reminded investors this week, the Fed is all too aware that buying longer dated securities can cause serious pension asset/liability mismatches.

Which brings us back to the Bank of Japan's long battle against deflation. For years now, the Bank of Japan has been buying Japanese Government Bonds (JGB) in a bid to pump cash into the financial system, which has been crippled by the reluctance of the banks there to lend money. This prompted a steep fall in Japanese bond yields, which this week did an about face and rose sharply higher on the central bank's tacit acquiescence that a speculative bubble may have been created in the JGB market.

Japanese government officials and economists welcomed these comments, but for strategists like Mr. Sowanick, it raised a red flag. And rightly so. As he points out, the Bank of Japan has been a major source of global liquidity, which has benefited the US because it allowed Japanese investors to step up their purchase of higher yielding US Treasury bonds. This has helped to fund the rapidly expanding deficit. If demand falls for these assets, then clearly something, either the dollar or interest rates, will have to adjust to attract the more than $1 billion a day the US needs to pay its bills. It will be very difficult for the Federal Reserve to control either of these especially now that it has let the cat out of the bag.

But is this a speculative bubble in US Treasury bonds? I think to some extent it is. As Steve Galbraith, Morgan Stanley's chief investment officer, points out, while

10-year annualised equity returns have fallen back to their long term averages since the collapse of the stock market bubble over three years ago, bond returns continue to run at over twice their long term historical averages. Furthermore, bond investors have continued to bid the market higher despite the marked improvement in the equity market. With the fundamentals for equities continuing to improve, it is very difficult to get excited about the bond market rallying much further from here, a view Mr. Galbraith concurs with. As he puts it: "Something has to give."

@EDITRULE:

Kees van Beelen is the fixed income portfolio manager in the Private Client Asset Management team at the Bank of Bermuda. The views expressed here are his and do not necessarily reflect those of the Bank of Bermuda at large. This report is not an offer to participate in any trading strategy and is based on public information. Every effort has been made to ensure that it is complete and reliable.