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Today the Bank of England announced that interest rates would stay on hold, and made no announcement concerning a new bout of quantitative easing (QE)

Frankly, the speculation in recent weeks of more quantitative easing QE to follow has been enough. Gold has hit a new all-time high; oil has surged in recent days, hitting a five-month high; while the price of government bonds has leapt.

What is all a little odd is that the forces driving the markets right now are contradictory.

Gold is traditionally seen as a hedge against inflation. Investors dig for gold when they fear inflation is set to rise. At such times you would expect them to avoid like the plague any kind of securities that pay out a fixed yield, such as bonds. And yet the yield on both UK and US ten-year government bonds is flirting with an all-time low.

And from that pretty yellow metal, to black gold. Oil rose to $83.62 last night on the New York Mercantile Exchange. It has risen in price by $10 in less than two weeks.

Price of oil 2004

So on the one hand we have investors rushing for gold, in fear of impending inflation. We see oil shoot up, providing a new inflationary pressure. And yet the yield on government bonds just keeps falling, suggesting markets are still anxious over deflation.

But the contradictions run deeper still.

Investors tend to opt for bonds when they fear the global economy is set for a downswing. Bonds are meant to represent safety.

And yet to a large extent, it’s the rush to safety that has caused the global economic crisis. If investors were to pour their money into equities and fund investment, and if in turn we saw a fall in savings across the globe, especially in Germany and China, with a corresponding rise in consumption, global growth would rise dramatically.

In short, it’s investors’ fears that are to a large extent causing the continued economic uncertainty. And yet oil is rising in the belief that demand is set to rise.

Do you see the paradox? If investors’ fears are justified, then oil should be cheap. In fact, according to the US Energy Information Administration, oil inventories in the US have increased in 15 of the last 17 weeks. So that’s odd. If inventories are rising, supply should be exceeding demand, and yet price has been going up.

Of course some might say the surge in bonds is down solely to QE. Markets anticipate that central banks are set to buy more bonds, therefore they force the price up in anticipation of this.

And yet, the surge in the price of gold suggests markets fear inflation. It seems a puzzle that investors would want to jump into bonds, which pay out a fixed yield, at a time when they are expecting inflation. After all, bonds are an awful bet at such times.

And to confuse matters further, China has been cutting its holdings in US bonds faster than you can say Wen Jiabao.

It seems there are only two possible explanations. One is that QE has distorted the markets, and that it has forced the price of bonds up even though markets fear inflation. The other explanation is simply this: no one knows. Investors are hedging against inflation and betting on deflation simultaneously.

We suspect the latter explanation is the most likely.

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