Bold yields plunge to 49-year low on interest rate and deflation fears

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The Independent Online

Fears of deflation and forecasts of further cuts in interest rates sent bond yields tumbling across the major western economies yesterday.

Prices of government bonds - a safe haven in times of low growth and inflation - surged in the UK, US and Germany, pushing yields to levels not seen for half a century.

The gloom swept through other financial markets, sending stocks down on both sides of the Atlantic and pushing the dollar to new lows against the euro.

However, a substantial rise in US consumers' confidence reversed the rout, delivering a lift to stocks, the dollar and bond yields. Consumer confidence rose moderately in May to a six-month high while sales of homes jumped in April as the end of the Iraq war, warmer weather and tumbling mortgage rates fuelled demand.

The early rush to buy bonds was triggered by Alan Greenspan's statement earlier this month that the Federal Reserve could buy US bonds as part of a strategy to avert deflation. In the UK the yield on the benchmark 10-year gilt hit a 49-year low of 3.95 per cent. The German bond plunged to an all-time low of 3.573 per cent while the yield on 10-year US bonds hit a 45-year low of 3.29 per cent on Friday.

John Maskell, head of European strategy at Barclays Capital, said: "Alan Greenspan has said to people that there's a risk of deflation which means you buy as many long bonds as you can."

Mr Greenspan also opened the door to further rate cuts, while analysts are increasingly betting both the European Central Bank and the Bank of England will follow suit to boost anaemic demand and offset falling levels of inflation.

The European Central Bank is expected to act first, cutting up to half a point off its 2.5 per cent base rate late this month.

Mr Maskell said he expected a further half-point cut in the summer. "The rise in the euro is destroying Europe and putting its economy in the bin," he said. "Rates will be at 1.5 per cent by the end of the year and that's a buy for European bonds."

The euro continued its appreciation yesterday, hitting its highest levels against the dollar, pound and yen since it was launched on 1 January 1999. It rose as high as $1.1925, 72.53p and 139 yen.

A stronger currency has increased the risk of deflation. The greatest threat is in Germany, the eurozone's largest economy, where low inflation means real interest rates are high. But there was little sign of panic among European officials, who continued to lend their support to the unofficial US policy of allowing the dollar to devalue. Ernst Welteke, the president of Germany's Bundesbank, said an exchange rate of $1.18 was "competitively neutral" for exports.

With little sign of support for the dollar, analysts revised their forecasts for exchange rate. Colin Warren at GFC Economics said there was a "growing risk" it would hit $1.40 during the coming year. "By downplaying the negative consequences of a tumbling dollar, the authorities have given a green light to the currency markets to extend the deflationary appreciation of the euro," he said.

The one mystery is the rise on the stock markets that - until recently at least - has accompanied the expansion of the bond market bubble. Stephen Lewis, chief economist at Monument Securities, said investors were betting on both a solid US recovery and on deflation. "Clearly they cannot simultaneously entertain both scenarios," he said.

He said the US was suffering from an excess of capacity and lack of demand rather than deflation, which was a monetary phenomenon.

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