Fixed-income inves–tors are seeking refuge from the global turmoil in the U.S. bond market, in which Treasury bill yields are headed to zero. Although investing money at a zero return may seem irrational, it makes sense — at least, in the short run — given the state of apprehension about European sovereign debt and other crises.

This flight from risk could drive U.S. three-month T-bill yields — which began June at 11 basis points on an annualized basis and fell to 6 bps on June 15 — down to near zero or even into negative territory, as happened for brief periods in the fearful days of 2008. On a macroeconomic basis, that situation could also signal the arrival of a spate of deflation, as fear of economic contraction and the fact of such contraction are two sides of the same coin. (It has to be said that the U.S. is not Japan, which has sustained two decades of price deflation.)

Deflation-induced gains in U.S. short-term bond prices are not likely to extend to Canada. This country’s economic fundamentals are better, as 90-day T-bill yields of 0.45% on an annualized basis are far from deflation or panic levels. In addition, the market for Canadian government debt is too small in relative terms to draw the interest of fright-and-flight global investors.

Deflationary forces are already at work, says David Rosenberg, chief economist and strategist with Gluskin Sheff & Associates Inc. in Toronto: “There is asset-price deflation and post-bubble credit collapse. Major retailers in the U.S. are cutting prices; apparel prices are down; rents in the U.S. are flat year-over-year to April 30; and the real price index is now running at minus 1%.”

If deflation angst grows, traders might find that prices of T-bills with at least a few months to run until maturity could rise. All this has brought the dreaded “D-word” back to investors’ spreadsheets. So, could a decline in the U.S. consumer price index really happen?

“What is staring us in the face is deflation,” says Chris Kresic, who will manage Montreal-based Jarislowsky Fraser Ltd.’ s fixed-income portfolio from Toronto when he joins the firm in late June. “The recovery is based on appreciating asset prices, and they are not appreciating any more.”

The rush to safety shows up in economic data. Yields on 10-year German bonds fell to 2.58% on May 25, the lowest in many years, paralleling the drop in 10-year U.S. treasuries’ yields to 3%. In commodities, copper prices dropped by 3.8% on May 31; crude oil futures fell by 2.9% the same day.

Adding to the fears that the world economy could be slowing, China’s purchasing managers’ index dropped in April. In the U.S., the Institute for Supply Management reported that its U.S. factory index had dropped significantly in April.

And the commodity smoothed price subindex of the U.S.-based Journal of Commerce’s industrial price index — the subindex tracks the prices of a diverse mix of cattle hides, tallow and burlap — plunged by 57% in May. Tallow and burlap don’t rival copper and oil as vital commodities, but this subindex — which is pure, in the sense that there is hardly any speculative trading in its components — also plunged just before the 2008 market implosion.
@page_break@More negative gross domestic product indicators could be ahead. Still, deflation has not been given official recognition. “What we have now is not a crisis, but fear of a crisis,” points out Rémi Roger, vice president and head of fixed-income with Seamark Asset Management Ltd. in Halifax.

The foundation for a bout of deflation — or, at the least, disinflation, which is a reduced rate of inflation — is the fact that measured rates of inflation in the G-7 countries are falling below central banks’ targets. More slowing in GDP seems to be in the works.

“U.S. core CPI data is running at a 40-year low, at 0.9% for the year-over-year period ended April 30,” says Patricia Croft, chief economist with Royal Bank of Canada’s global asset-management division in Toronto. “Part of the reason is the China story about slowing growth, and part of it is the fact that bonds are already pricing in a sluggish recovery.”

Equities markets have also become risk-averse. The MSCI world index has fallen by 10% year-to-date — and with reason. The oil spill disaster in the Gulf of Mexico could lead to reduced issuance of drilling permits by the U.S. and other governments that control offshore waters. The result — higher oil prices — would be a tax on the global economy that would slow output. Furthermore, the two Koreas are exchanging military threats, stemming from the sinking of a naval vessel belonging to the South by a torpedo allegedly from the North. Then, there is also the escalating political crisis in the Middle East.

For now, the risk of buying U.S. government debt is currency loss. And managing that risk is a question of timing, says Matthew Strauss, senior currency strategist with RBC Capital Markets Corp. in Toronto.

“The U.S. dollar could decline against the Canadian dollar,” he explains. “We see an appetite for risk returning to global markets and that could moderate the stampede to the US$ against other currencies. The prospect that the U.S. Federal Reserve Board will raise rates before the end of 2010 should be a counterweight to a decline of the US$. That would tend to reduce the currency risk for a Canadian investor buying U.S. government debt at very low yields.”

The implication: it may be necessary to wait a few months to get out without a currency loss until fear returns to repress currency fundamentals.

Central banks are trying hard to maintain a measure of price stability and thereby allay the risks of price declines — the essence of deflation. The European Central Bank has been buying government bonds as a way to maintain bank reserves in response to the widespread sell-off of Greece’s, Portugal’s and Spain’s sovereign debt. Buying bonds from the national banking systems injects cash into the respective economies. The effect is to drive down bond yields.

If quantitative easing continues and if investors continue to flee from equities risk, T-bill prices will rise, says Tony Warzel, president and chief investment officer with hedge fund Rival Capital Management Inc. in Winnipeg.

Deflation is what makes the trade work, he adds. If bond or T-bill prices drop by 1%, a 2% drop in the CPI will provide a 1% real return. If deflation worsens or if fear of it stimulates momentum investing, then the client who buys bills or bonds at a 1% premium over redemption value could be rewarded by a sale at 2% over redemption value.

“Central banks are running out of arrows to shoot at the problem,” Warzel says. “Real U.S. overnight rates are below zero. If there were a larger sense of deflation, then consumers would postpone purchases in order to buy at still lower prices.”

As a tactical move to protect portfolios, short-term U.S. bonds look right for these times. That’s why they continue to be bought in spite of their low nominal yields. IE