Government bonds gain favor as fears of second recession grow

Epic financial collapses are supposed to be rare events. Once in a lifetime, we all hope.

And after you live through one, your investment decisions are forever colored by the experience. That explains many investors’ extreme risk aversion since the markets’ crash of late 2008.

Now, the risk-averse are being forced to ponder whether they feel safe enough given what might be coming at them.

At the depths of the recession it was more than rhetorical to ask, “What’s the worst that could happen?”

Here we go again.

Much of the important economic data of the past few weeks have pointed to slower growth in the U.S. and overseas. That has been enough to spark another worldwide sell-off in stocks, though a modest one compared with what hit the markets in the spring.

More striking has been the rush to buy the bonds of governments that investors believe will always find a way to pay their debts – the U.S. and Germany, for example.

The already low market interest rates on those bonds fell further last week as more buyers piled in, happy to accept ever-shrinking yields in exchange for a sense of security.

With the annualized yield on 10-year Treasury notes at 2.68 percent on Friday, a 16-month low, “The bond market is telling you a very pessimistic story” about the economy, said Bill Strazzullo, market strategist at Bell Curve Trading in Freehold, N.J.

In other words, the fear pushing bond yields down isn’t about whether the world is facing just a temporary economic slowdown. Rather, it’s dread of another calamity: a further shrinkage of the economy that would set off a deflationary spiral, meaning a broad and sustained decline in prices of goods, services and assets.

Worries about deflation surged amid the credit crisis of 2008, then largely went away as the global economy rebounded last year. They have roared back over the past two months as the U.S. recovery has ebbed while a key measure of inflation has held below the 1 percent level.

On Friday, the government’s report on July retail spending provided more evidence of an economy that is struggling, though not collapsing. Excluding auto and gasoline purchases, retail sales slipped 0.1 percent from June as many consumers apparently kept their wallets closed.

A separate report on the main U.S. inflation gauge, the consumer price index, showed that prices overall were up 0.3 percent in July from June, the biggest rise in a year, boosted by a jump in energy costs.

But the more closely watched “core” index, excluding food and energy expenses, was up just 0.1 percent from June. And the year-over-year increase in core prices has stayed at a mere 0.9 percent for the last four months – the slowest rate of inflation in 44 years.

A slide into actual deflation in the core index may be less likely in the near term because of the effect of housing costs, which account for about 32 percent of the CPI overall. Rising rents in many parts of the country could offset downward pressure on other prices.

Still, the danger of tipping into deflation obviously increases as growth slows.

“We know the economy is losing momentum fast,” said Mohamed El-Erian, chief executive of bond fund giant Pimco in Newport Beach, Calif.

He now believes there is a 1-in-4 chance of the U.S. sliding into deflation.

But as horrid an event as deflation has been made out to be, the truth is we can’t be sure what it would actually mean.

The images it conjures are from the 1930s, with widespread falling prices, wages and asset values.

Yet Japan’s deflationary backdrop of the past two decades hasn’t gutted its economy. The country’s growth overall has been sub-par, its stock market has been abysmal and consumer prices have been in a sustained decline, but Japan remains an industrial powerhouse with a high standard of living.

It’s conceivable that the U.S. could experience a mild deflation with a quarter or two of negative economic growth that would give way to a pickup in growth in 2011.

Conceivable, maybe, but too dangerous to risk, says Jim Bianco, head of bond research firm Bianco Research in Chicago.

“We’re at the point where it becomes very important that we don’t slip back,” he said. A double-dip recession “could mean that (Americans’) confidence could be shot for many years.”

With the private sector creating few jobs, the employment picture would only worsen if businesses began to expect a double dip and cut costs preemptively.

And any slide into a deflationary recession would almost certainly mean a new dive in stock prices and in the value of other assets, including real estate.

By taking yet another step to try to avoid deflation – pumping more money into the financial system via bond purchases – the Fed last week did as many analysts expected.

But the central bank also runs the risk of fueling pessimism about the economic outlook.

With the government already having tried so much in terms of lowering interest rates and spending massively on stimulus, “I think people are realizing that policy is becoming less effective” in influencing the economy, Pimco’s El-Erian said.