U.S. and German Bond Yields Plunge, Signal Deflation

The only bull market these days lies in the Treasury bond market. While virtually all other assets have plunged in value in a miserable 2008 for investors, T-bonds remain highly bid amid a rapidly contracting American economy.

The benchmark ten-year Treasury bond opens this morning yielding 2.97% -- the lowest yield since the late 1950s and breaking the previous post WW II low of 3.29% set in June 2003.

Over the last 12 months ten-year Treasury bonds have gained a cumulative 13.9% compared to a crushing loss of 40% for the S&P 500 Index and a chilling 29% decline for commodities as measured by the Reuters-CRB Index.

The entire spectrum of non-Treasury bonds has also declined, except fixed rate mortgage-backed securities, up 7.2% since November 2007. Junk bonds, emerging market bonds, municipal bonds and corporate bonds have all suffered big losses this year.

With stocks crossing 1997 levels following last week’s decline, investors continue to scramble to the short end of the U.S. yield curve or, mainly, short-term Treasury’s. Benchmark two-year T-bonds yield just 1%.

In Europe, government bonds are also attracting safe haven inflows, mainly German bonds, or bunds. This, despite a failed German government bond auction two weeks ago where even the almighty Germans couldn’t raise their targeted auction goals. Since September, several other weaker Euro-zone governments scrapped weekly auctions because of poor investor demand, including Belgium, Italy and Austria.
Germany, though probably in recession, is in far better economic shape than her neighbours with mortgage speculation far more muted compared to Ireland or Spain and consumers harbouring among the highest savings rates in Europe at 13% of GDP. Unlike Spain or the United Kingdom, the Germans didn’t leverage their economy to the same extent relying on mortgage financing.

Benchmark German government debt has soared since September at the expense of weaker credits like Italy, Spain, Greece and Belgium where comparable bond yields have ratcheted higher because of rising credit default risk. The market has started to gradually discount the possibility of European government funding shortfalls, namely in those markets where economic growth has fallen off a cliff and funding auctions has grown more expensive.

There’s no doubt that global government funding obligations are set to skyrocket over the next 12 months as the Treasury and the European Union raise record amounts of debt to finance global bank bailouts and other failed industries, including broad consumer fiscal measures to alleviate growing economic hardship. Bond yields will eventually rise once calmness is restored in world markets. But for now the best game in town – and certainly the safest strategy – remains buying intermediate-term government debt in the United States and Germany.

Deflation has arrived, and only government debt will appreciate in value in an environment otherwise hostage to plunging prices and declining global demand.

Have a good Thanksgiving Holiday weekend. See you on Monday.