Government Bonds have been the only place in town so far in 2010. Is the unexpected rally in bonds a sign that investors feel deflation has gained the upper hand or are we witnessing yet another asset bubble in the making?

A look at government bonds over a longer term. The US 10-year government bond yield since the late 1970s is a good proxy for the developed markets.The yield on the US 10-year bond declined continuously from a brief spike to near 16% in late 1981 to a low of just above 2% in 2008. The rally in bonds in 2010 has brought the US 10-year bond yield down to 2.6% and approaching the lows of 2008.

A declining bond yield reflects rising bond prices. In practice, then, rising bond yields reflect falling bond prices and declining bond yields, as has been the case in the developed world since the early 1980s, reflect rising bond prices.

Negative real returns in the 1950s, 1960s and 1970s gave way to the super-sized positive returns in the 1980s, 1990s and 2000s. In fact, over the past 30 years, real bond returns after inflation in both the US and UK have been on average 5.9%. The US 10-year bond currently yields 2.61%. Based the long term real return of 2.1%, then investors must be expecting US annual inflation to average only 0.5% over the long term from here.

And now back to the key issue – is there a bubble in bond valuations? My own view, is that I feel the mentality of the US and UK governments has always favoured growth and jobs over inflation. With visible cracks in the Euro-zone,Germany’s resolve to such inflationary tactics could easily weaken. For these reasons, I believe bond yields at these levels represent bubble valuations!