If you have walked the streets of Paris recently, you might have noticed that the ‘boulangeries’ are making place for sushi shops. Europeans are changing their eating habits – full butter croissants are out and skinny sushi rolls are in. Similar to the Japanese experience, this same story is playing out in European bond markets where yields on government debt are looking skinnier by the day.
What happened in Japan?
In the early 1990’s, Japan experienced a major economic crisis triggered by the collapse of the housing and stock markets, in part fuelled by easy credit conditions. The subsequent correction began a deflationary spiral which magnified the problems of the heavily indebted economy. Today, Japanese government debt stands at over 220% of GDP, by far the highest in the developed world, and is expected to increase according to the latest figures from the Organization for Economic Cooperation and Development (OECD). Almost two decades after this crisis, Japan is still battling against low inflation and growth.
Why is it similar to Europe?
Firstly, a similar crisis began in Europe in 2008 where high debt levels and asset prices unwound with a crash and today, eight years forward, Europe is still combating persistent low growth and inflation. Since the crisis, government debt to GDP levels have been rising steadily in the Euro area reaching all-time highs similar to the Japanese experience. This is important because it means governments have little ammunition to stimulate their economies, relying instead on the central banks to do the heavy lifting. In both cases the central bank’s response has been similar, expanding their balance sheet in an attempt to revive their flagging economies. The result so far has been ever lower government bond yields without growth or inflation improving.
What is the market telling us?
The chart below illustrates how long term interest rate expectations for Japan, Europe and the US have moved over the last 25 years. We’ve used 5y5y swap rates which give 5 year interest rate expectations in 5 years time. We can draw two powerful conclusions from this chart. Firstly, Europe is decoupling from the US and moving towards Japanese levels. Secondly, the current European 5y5y swap rate is below the European Central Bank’s long term inflation target of 2%, which is all the more remarkable as swap rates include both growth and inflation expectations. This means that the market believes Europe will be in an exceptionally low interest rate environment for a prolonged period of time, just like Japan.
European inflation expectations are approaching Japanese levels
What does this all mean for bond investors?
The widely reported 30-year bull run for bonds was meant to have come to an end. If we can learn anything from the Japanese case, deflationary pressures and extended periods of low interest rates may be here to stay. European investors will need to broaden their investment horizon in order to find the yield on their investments they were once used to. One way to take advantage of this low yielding environment is by investing in flexible fixed income strategies that seek to find the best investment opportunities no matter in which part of the world they are to be found.
If you’re hungry for yield, why not have burgers for lunch instead?