5 Min Read
* Bund yields reach Japan-like territory around 1 percent
* Pressure on the ECB to buy bonds increases
* Markets still see inflation eventually hitting ECB target
* Bunds seen safest place to be if ECB fails on inflation
By Marius Zaharia
LONDON, Aug 15 (Reuters) - German Bund yields at 1 percent are stoking fears that the euro zone faces a "lost decade" of economic stagnation and incessant struggle to lift inflation, similar to that of the only other country where borrowing costs hit such levels - Japan.
At the same time, another indicator in the bond market shows investors expect inflation will eventually rise to the European Central Bank's target of just below 2 percent.
The discrepancy suggests that markets are banking on the fact that the ECB will take new monetary policy easing measures to lift price growth and explains why investors are willing to buy assets that, on the face of it, might lose them money.
And even if the ECB, like the Bank of Japan, fails to lift price growth, investors see value in Bunds because the top-rated asset should offer them protection from any reignition of the debt crisis that the lack of inflation might trigger.
"A break below 1.0 percent will arguably see the ongoing debate as to the possible Japanification of Europe growing substantially more voluble," said Richard McGuire, senior rate strategist at Rabobank.
"This, in turn, would very likely ratchet up the pressure on the ECB to do more."
Financial markets' and the ECB's preferred measure of the inflation outlook, the five-year, five-year forward breakeven rate, which measures roughly where investors see five-year inflation rates in five years' time, stands just above 2 percent.
After the ECB cut all its interest rates in June and promised long-term cheap loans to banks (TLTROs) from September, investors are increasingly betting the central bank will eventually buy bonds and print money - a monetary tool known as quantitative easing (QE).
This would allow investors to profit from buying Bunds yielding 1 percent if they sell them later to the ECB at a higher price - and implicitly a lower yield.
Ten-year German yields, the benchmark for euro zone borrowing costs, traded at 1.01 percent on Friday, having hit a record low of just below 1 percent the previous day, after data showed the euro zone economy stagnating in the second quarter and July's final inflation figures at just 0.4 percent.
The chances of much faster growth without ECB intervention are slim. Tit-for-tat sanctions imposed by Russia and the West over the crisis in Ukraine, where pro-Moscow separatists are fighting government forces, are just starting to bite.
"The numbers on the growth side are not encouraging at all," said David Keeble, global head of fixed income strategy at Credit Agricole, adding that the fact that longer-term inflation expectations remained anchored around 2 percent was "a vote of confidence" in the ECB.
"The market is pricing in proper QE if the TLTROs don't work," he said.
Equivalent Japanese bonds yield 0.50 percent. They first hit 1 percent in 1998 and the Bank of Japan's constant struggle to lift inflation meant that they have not moved more than roughly 1 percentage point away from that level ever since.
Ten-year yields had never hit 1 percent in any other country before. U.S. yields troughed at 1.36 percent in 2012 at the height of the euro zone crisis when investors were seeking assets perceived as safe havens.
That episode, in fact, offers another argument for buying Bunds for returns lower than the expected inflation. German debt is seen as one of the safest assets in the world.
If the ECB fails to lift price growth in the medium term, the euro zone crisis might reignite and at that stage investors will be concerned about getting their money back rather than a return on their assets.
Countries such as Spain and Italy, which were at the forefront of the crisis two years ago as they were seen as too big to bail out, badly need inflation to be able to stop their 3 trillion euro combined debts rising further.
"Italy is at risk at some stage of restructuring its debt. It's very hard with inflation at zero ... to stabilise the debt," said Robin Marshall, director for fixed income at Smith & Williamson.
"Bund prices add a bit of discount for the risks in the periphery ... But we've hit 1 percent without a true crisis in the periphery so you begin to wonder where we would go if we actually had a crisis." (Additional reporting by Emelia Sithole-Matarise; Graphic by Vincent Flasseur; Editing by Susan Fenton)