* 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 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
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 &
"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)