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Europe is no Japan (yet)

As low as the yields on European credit may seem, the asset class seems to have defied (at least for now) fears of Japanification. To start with, whereas the 10 year German yield tested (over Q1 2015) levels that were lower than those experienced by the deflationary icon, in the meantime it rebounded to about 0.8%, which is almost double the 10 year Japanese yield. At the short end of the curve (less than 5 years), German bonds are however yielding less than their Japanese peers, likely because the negative deposit rate introduced by ECB and the QE programme resulted in a supportive technical backdrop.

The divergence at the longer end seems in turn to suggest that investors see the longer term growth and inflation as being higher in Europe than in Japan and that they do not expect Europe to linger at current levels for as long as Japan did. Indeed, the market measures of long term inflation (5 year-5 year inflation swap) are dismal for both regions but higher for Europe than for Japan (1.8% and 1.2% respectively).

Personally I am sceptical that such figures will be enough to prevent a reversal in German yields to lower levels. After all, the Japanese figure has improved significantly from its lows but still has not translated into higher yields. To put it differently, perhaps what is more important is the absolute level of long term inflation expectations and how they compare with the 2% threshold deemed “healthy”.

Otherwise, all things equal, QE should push yields lower, more so in the Euroarea where the budget deficits are much lower. In Japan, the budget shortfall is likely to amount to about 6% of GDP, implying the need for sizable bond issuance/roll-down, whereas for Eurozone the deficit should be in the 2% region.

As regards the corporate spreads, the EUR Investment Grade (IG) does not show any evidence of Japanification. Indeed, spreads in Europe are much higher than in Japan standing at 1.2% as opposed to 0.2%! Moreover, whereas the JPY IG spread curve is virtually flat, in Europe spreads are increasing with maturity (from 0.8% for the 1-3 years bucket to 1.45% for the 7-10 years bucket). What is more, in Japan the spreads have hardly moved this year, whereas the EUR credit has widened from 0.9% to 1.2%. Hence, in the eventuality that Euroarea yields turn again lower and the search for yield gathers pace again, one could expect the IG spreads to fall and the curve to flatten as investors move into longer maturities. Having said this, the process would likely be gradual as for the moment the issuance of corporate bonds remains a concern given the drive to take advantage of the low yields to extend debt maturities.

Have a nice day!