German inflation data for January showed that despite a surge in health-care costs, price pressures in Europe's largest economy remained relatively subdued, partly as a result of the strong Euro.

Without these new charges instituted by the German Health and Social Affairs Ministry, inflation would have actually fallen. With consumer demand still quite weak, there appears to be little pricing power in the European economies, underscoring the growing deflationary pressures there.

Many economists now argue that this, together with the strong Euro, gives the European Central Bank plenty of latitude to cut interest rates. Year on year inflation in the European Union as a whole grew a paltry 1.1 percent in January and earlier in the week, the ECB's President, Jean-Claude Trichet, said that he expected it to fall below the central bank's two percent target and stay there this year.

The ECB however, is still playing the prospect of lower European interest rates very close to its chest, with Mr. Trichet calling the current benchmark rate of two percent appropriate. Nevertheless, the implied interest rate on the three-month Euribor futures contract, which jumped to 2.25 percent at the beginning of the year, continued its decline, hitting 2.05 percent, suggesting that the market is now much less worried about the prospect for higher European interest rates.

All of this also comes on the heels of Federal Reserve Chairman Alan Greenspan's comments last week, where he said the US central bank "can be patient" about tightening monetary policy given that inflation remains so low.

Notwithstanding other reasons given such as the lack of job creation, as well as the extent of excess capacity in both the product and labour markets, core inflation in the US is still languishing at its lowest levels in almost 50 years.

Real disposable income depends on job and wage growth and the string of disappointing US employment reports raises a number of troubling questions regarding the sustainability of the recovery, especially given the staggering increase of household debt. Taken together, it is not too surprising then that the consensus view for higher interest rates is now pushed much further into the future and bond prices have continued to rally.

So what now for fixed income investors? A recent survey by Ried, Thurnberg & Co. showed investor sentiment towards the US Treasury bond market was still near its lowest level since August 1990, despite the market's recent rally. Convexity, credit and duration, the three most fundamental areas of return for fixed income investors, are hardly attractive at current levels, but that is quickly being eclipsed by the fact that the threat of higher yields has been greatly reduced in both the US and European bond markets.

Interestingly enough and despite the apparent abhorrence for Treasury debt, open interest in both the US and European futures markets have also risen to historical record highs over the last two months. It seems that leveraged investors such as hedge funds have been building long outright positions in the ten-year part of the yield curve. Emboldened by the fact that interest rates are not going up, given the macro fundamentals outlined already, hedge funds seem confident in extending duration, despite a surge in economic growth, in order to take advantage of the huge positive carry the steep yield curve affords.

The steady bid from Asian central banks, who have been buying US Treasury bonds in an attempt to stem the rapid decline of the USdollar, has also no doubt played into this strategy.

A sudden unwinding of this leverage would be very painful. One could also argue that the biggest problem facing the Federal Reserve in the future will be engineering a soft landing for a economy flying high on cheap leverage afforded to it as a result of the campaign against deflation. But the Fed has time on its side, so the short-term risk to this trade, particularly from the perspective of an inflationary shock sending yields higher, is quite negligible.

Furthermore, considering that the meagre real returns at the short end of the yield curve, investors can still be lured to extend the maturity of their portfolios if they too become convinced that interest rates are likely to remain low for some time yet. Getting below four percent in the ten-year part of the curve could persuade investors to throw in the towel and get long. Remember that the bond market has already proved to be much more resilient than anyone had expected.

The signs seem to be lining up for another rally before this party is over.

@EDITRULE:

Kees van Beelen is a portfolio manager at the Bank of Bermuda, a wholly owned subsidiary of HSBC. The views expressed here are his and not necessarily the Bank's.