Great Graphic: Is Germany Going Where Japan has Never Been?

There are a number of investors and economists that argue that where Japan was, there the Europe and the US are going. Most recently they are emphasizing Europe following Japan more than the US.  

Although we recognize some similarities, we suspect they are superficial in nature.  For example, the deflation that has gripped Japan is qualitatively different than the deflation being recorded in the euro area.  The deflation in the eurozone is primarily a function of the drop in oil prices.  Core inflation, as we will see with tomorrow's preliminary release, remains positive.  

Both the eurozone and Japan have bank-centric models of capital distribution, in contrast to the US, for example, that relies on the markets more than banks.  We recognize that the banking crisis hit area and lingered for years.  However, there is great divergence between the health of eurozone banks, especially along regional lines.   

In addition, the role of German in the monetary union knows no parallel in Japan.  The role of bunds is different than JGBs.  The ownership of JGBs is largely domestic. They are hardly used as reserve assets.  The German bund is a different animal.  It is owned widely and used as a reserve asset.

This Great Graphic, created on Bloomberg shows the yield of the (generic) 10-year German bund (white line) and the 30-year JGB (yellow line).  The 30-year bund yield has fallen below the 30-year JGB yield.  Not shown on this chart, but the JGB 30-year yield did, according to Bloomberg data fall to 91 bp in 2003.  The low since the BOJ's QQE was announced was set earlier this month near 1.07%.  Today the German bund yield fell below 1.03%.    Further declines are likely.  

There are three considerations.  First, the German preliminary January CPI fell to -0.3% from +0.2%in December.  This was a greater decline that the consensus expected.  As we noted earlier, the Bundesbank is opposed to the ECB's bond buying.  But besides saying "nein" and expressing concerns about moral hazard, they have not offered alternative proposals to achieve their legal mandate, price stability.  The legal requirement to achieve price stability has been emphasized by ECB President Draghi.  The logical conclusion of some of the comments from BBK head Weidmann is to focus on core inflation, but as much as we have argued for this, it has not been picked up by others.  

Second, the ECB's sovereign bond buying program requires the purchase of about 100 bln euros of German bunds.  There is already a shortage of the AAA asset.  In addition, new supply will be limited as the German coalition government (CDU/SPD) projects a balanced budget this year. Moreover, the debt office plans on paying down some of Germany's debt, which means overall supply will shrink.  

Third, doubts about the sustainability of monetary union have resurfaced.  Many euro skeptics were silenced by the ECB's pledge to "do whatever it takes" to defend monetary union.  However, in light of the Greek election, all the old arguments have returned.  Monetary union before political union has never worked.  The tax payers of the creditor nations have been bled dry and have little appetite to give more.  Although we have problems with these assertions, the point here is that they have resurfaced.  The last time German 30-year bund yields fell below similar JGB yields was as the last phase of the euro zone crisis peaked around the middle of 2012--before Draghi's pledge.  In this light, the German bund has an embedded call option on a new German mark, which can be expected a strong currency if the EMU were to end.