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From jittery to joyful, bond markets cheer Fed

A 20-year bull run in government bond markets, which has sputtered this year, just got a new lease of life thanks to the U.S. Federal Reserve.

The central bank ended a two-day meeting on Thursday with a decision to keep interest rates at record lows for a while longer amid an uncertain outlook for the world economy.

Federal Reserve Board Chairwoman Janet Yellen answers questions at a news conference following a Federal Open Market Committee meeting Sept. 17, 2015, in Washington, D.C.
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Federal Reserve Board Chairwoman Janet Yellen answers questions at a news conference following a Federal Open Market Committee meeting Sept. 17, 2015, in Washington, D.C.

Its dovish tone triggered a dive in U.S. and European bond yields, which could have further to fall, analysts said. When bond yields fall, the price rises.

"Long bonds – let's say the 10-year Treasury yield – is a function of the forward-looking interest rate from the Fed," Alain Bokobza, head of global asset allocation at Societe Generale, told CNBC's "Squawk Box Europe."

"And for this, the more you downgrade the forward-looking view given by the Fed to the market on where the Fed Funds rate will be in a year, you also downgrade the 10-year bond yield forecast, which is what happened yesterday," he said.

Dive

The yield on the interest-rate sensitive two-year Treasury yield was trading at 0.67 percent on Friday, having tumbled about 13 basis points the previous session.

Deutsche Bank said the fall marked the biggest single move lower in two-year yields since March 2009, when the Fed unveiled its massive bond-buying program.

Earlier this week two-year yields hit their highest levels in more than four years at 0.819 percent amid jitters that the Fed was about to embark on a rate hiking cycle for the first time in almost a decade.

"We are not that pessimistic on the Treasury markets," said Bokobza.

European bond yields meanwhile fell in step with the U.S. counterparts, with the benchmark German 10-year Bund yield down more than 10 basis points at 0.67 percent on Friday and 10-year yields on U.K. government bonds tumbling 12 basis points to 1.84 percent.

"We would argue that a less hawkish FOMC (Federal Open Market Committee) should clearly be bullish for European markets as well," analysts at RBC said in a note.

"10-year Bund yields had prior to the Fed meeting traded close to 80 basis points again which has acted as a good support level previously. We would expect a retreat towards lower bound of the recent range near 60 basis points again," they said.

What rout?

Uncertainty about the timing of U.S. rate hikes – anticipated this year as the economy shows signs of strength – and a view that bond yields had fallen too far triggered a sell-off in global bond markets earlier this year.

Following Thursday's rate decision, markets appeared to pushing back expectations for a U.S. rate hike into 2016. According to Deutsche Bank, markets price in an 18 percent chance of rate hike in October and a 44 percent chance of one in December.

"We think spreads in the U.S. remain too tight compared to fundamentals and we think the dovish message sent by the FOMC will be seen as a 'green light' for investors to put more money to work," analysts at Mizuho said in a note. "In this instance we think spreads have a lot further to widen."