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ber bears go bullish on bonds as deflation threat looms

DURING the summer months global stock markets have rallied beyond what even die-hard bulls would have thought possible six months ago. Yet this is perhaps not the most surprising trend to have emerged out of the typically quiet August period. Strategists on both sides of the Atlantic have been trying to get their brains around why both equities and government bonds (and US Treasuries in particular) are both doing so well. As a rule of thumb, when stocks rally, bond prices tend to fall and yields rise. But the stock market has rallied by more than 50 per cent in the last five months yet the yield on US 10-year Treasury is currently hovering around 3.38 per cent compared to the 3.93 it hit in mid-June. <br /><br />There are two possible explanations for this dichotomy. Firstly, as governments across the developed world financed their billion-dollar stimulus packages through issuing record quantities of bonds, the price of government bonds fell and longer-dated yields rose sharply. <br /><br />But as signs of a sharper-than expected recovery become more apparent, investors are less worried about another sharp increase in government issuance and expect slightly fewer bonds to be issued than previously predicted. Falling supply, theoretically, ought to increase the price of bonds and thus reduce yields. <br /><strong><br />DEFLATIONARY THREAT<br /></strong>However, a more worrying reason was expressed last week by &uuml;ber-bear Albert Edwards of Societe Generale. Instead of the previous, more optimistic scenario, it could be that the bond market foresees a deflationary threat.<br /><br />He says: &ldquo;Despite clear signs from the business surveys of some sort of second half recovery, firm evidence is emerging that the global economy is sliding towards a full-blown deflationary episode once this recovery falters.&rdquo;<br /><br />He adds: &ldquo;It is clear to us that the ongoing march into outright deflation will accelerate during this short-lived economic recovery, while post-bubble realities will force commercial banks to aggressively step up their buying of government bonds,&rdquo; like they did in the 1990s US credit crunch.&rdquo; <br /><br />This will underpin rising bond prices and falling yields as demand steps up. Also supporting Edwards&rsquo; bullish stance on&nbsp; government bonds is the fact that investors are unwinding their over-exposure to bubble sectors like real estate and switching into assets like Treasuries.