THE NEW BOND CONUNDRUM / THE WALL STREET JOURNAL

HEARD ON THE STREET

SEPTEMBER 8, 2009, 11:39 A.M. ET.

The New Bond Conundrum

By RICHARD BARLEY

Policy makers must be pretty pleased with themselves. Global bond markets seem to be accepting the mantra that official interest rates can be sustained at extremely low levels, helping to boost the economy without causing an inflation problem.

U.S., U.K. and European bond yields have fallen over the past month, with two-year German government bond yields hitting a low of around 1.04% Tuesday, even as equities climbed and risk appetite built. There will be a reckoning at some point -- but it could be a way off yet.

Admittedly, there are heavy inducements on offer for buyers of government bonds. The U.S. Federal Reserve and the Bank of England are buying directly, reducing the supply overhang. The European Central Bank is offering unlimited, cheap 12-month refinancing facilities, much of which is finding its way back into the bond market via banks building liquidity reserves.

Meanwhile, doubts remain about an economic recovery, particularly once temporary effects such as cash-for-clunkers programs or inventory restocking wash through. That makes it more likely that stimulus policies and low rates will remain in place.

Still, tension is building. Short-dated yields may stay low for some time yet: in Europe, Barclays Capital notes they only start to rise in earnest about six months before the first rate hike, which may only come in the second half of 2010.

But market expectations could move quickly if data starts to depict a recovery that goes beyond inventory restocking and emergency one-time stimulus effects. Volatility could spike as the U.S. and U.K. authorities wind down their bond purchases. The fine line authorities are treading between awakening risk appetite and keeping the bond market onside could then become much harder to walk.