Fears of deflation spark a rush for government bonds

The spectre of looming deflation drove government bond yields on both sides of the Atlantic to historic lows yesterday as nervous investors sought sanctuary from the turbulence in equities and other asset classes.

Some US Treasury bills were quoted at 0 per cent, while the two-year note and the 30-year bond recorded their lowest yields since they were first regularly issued in the 1970s. The five-year note was at its lowest since 1954, based on historical data from the Federal Reserve. In the UK, the two-year gilt yield dropped to its lowest level since since the second world war.

Buying government bonds as a safe haven investment has dominated flows in recent months. The latest moves come as increasingly worrying economic data point to rising unemployment and plunging inflation.

"Given the recent deflationary data, not just in the US but globally, the world is starting to build in a Japan-style deflationary scenario," said Jim Caron, head of interest rate strategy at Morgan Stanley.

Recently, the Federal Reserve's effective Fed funds rate has traded at around the 0.25 percentage point level, well below the target rate of 1 per cent. Meanwhile, Treasury inflation securities have moved to price in deflation for the next nine years.

Bill O'Donnell, strategist at UBS, said the bond market was reacting to the very low effective Fed funds rate and the possible start of a deflationary period.

"The mood is 'give me Treasuries at the expense of all other asset classes' as spreads blow out and stocks slump," said Mr O'Donnell.

Tom di Galoma, head of Treasury trading at Jefferies & Co said: "There is no place to hide but in US Treasuries. You cannot hide in corporate or mortgage bonds."

Deflation fears drove the 30-year swap rate to more than 50bp below that of the 30-year bond yield.

Some investors are using swaps rather than buying bonds to keep their cash reserves intact as they seek greater exposure to long-term rates.

"If you already have a portfolio, using swaps allows you to increase duration without liquidating cash bonds," said Jay Mueller, portfolio manager at Wells Capital Management.

The demand for long-term debt pushed the 30-year bond yield to a new record low of 3.71 per cent yesterday. Meanwhile, the two-year note traded as low as 0.96 per cent.

Meanwhile, recent weak UK inflation numbers and expectations that the Bank of England will cut base rates from 3 per cent to 1 per cent by February pushed the yield on the benchmark two-year gilt to a low of 1.92 per cent.

"This is about the collapse of inflation from official numbers this week and the very real spectre of disinflation in the UK," said Moyeen Islam, fixed income strategist at Barclays Capital. "We expect yields will go lower as inflation is likely to be negative between May and October next year."

The yields on the two-year German Schatz fell to levels not seen since September 2005.

Yield spreads between Germany, the most liquid and deepest bond market in Europe, and other eurozone countries, also widened as it continued to outperform.