Are government bond markets signalling that they expect deflation or are they just expecting low rates for a very long time combined with central bank buying to keep yield levels low?

Vast quantities of money have been created by the Fed and BoE but this money has yet to enter the real economy and most of it has been deposited by commercial banks back at their respective central banks.  It’s a bit like printing a huge wad of cash and then burying it in a suitcase at the bottom of your garden.  This money is not actually circulating in the economy and is not available to drive the prices of goods & services higher.  This is why QE has yet to create any inflation.  The result of QE and the proposed QE2 programs have been to lower bond yields and to allow companies and households to borrow more cheaply than would otherwise have been the case.  Credit spreads may be high but absolute rates being paid by borrowers to borrow money are at historic lows (e.g. US 30-year mortgage rates were recently 4.27% and have never been lower since the data started to be collected in 1971).  Companies in particular are keen to term-out their borrowing at coupon rates which represent historic lows for them.  It is in this way that the central banks are easing borrowing conditions further despite short rates being stuck near zero.

High credit spreads are allowing banks to make big profits which is helping them to meet the higher capital ratios being demanded by their regulators and the Basel III rules.  Vince Cable is getting upset on behalf of the government because bankers seem to think these high profits are a result of their skill rather than being a gift from their governments and central banks.  Hence continued high bonuses in the banking sector are troubling the Con-Lib government which will eventually feel forced to legislate against the bankers.

The bond markets are likely to be supported by QE purchases from the Fed & BoE but that does not mean that they are good value for investors.  Professional traders who employ stop losses are the ones who will profit from the bond markets continuing to rally and they will be able to switch tack and ride bonds back down again when yields do eventually back up.  Have no doubt that this bond party will end, probably on the day we get a very strong Non-Farm Payroll number in the region of +300,000 or higher.  Jobs growth of this order is what the Fed wishes to create and when they achieve their ambition they will scale back their latest QE program and start thinking about gently raising rates.  The reaction in the bond markets will be far from gentle.  The irony is that government bond prices are being forced higher by central bank buying but once the central banks achieve their aim they will stop buying bonds and, because they are the only buyers at these low yield levels (2.5% Treasuries & 3% Gilts), the fall in bond prices will be sharp & savage when the bond markets finally move to price in the end of QE. 

Eventually the economy will respond to repeated rounds of QE, unemployment will start to trend lower and the current bond market bubble will burst.  The bursting of the bond bubble will be spectacular and will rival 1994 in its ferocity.  We might see a strong employment report today, next month or not for another year – who knows.  Just don’t get caught long bonds when it happens.