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German vs Japanese bond yields

Bund yields don't herald another Japan

June 2019

Luca Paolini, Chief Strategist

Bund yields have hit new lows. But this doesn't mean Germany is turning Japanese.

Germany isn't turning Japanese. Which is why the relentless decline in German government bond yields is unjustified.

The yield on 10-year bunds – German government bonds – fell to an all-time low of -0.21 per cent on the last day of May as global markets panicked about US President Donald Trump’s threat to impose tariffs on Mexico. The flight to safety boosted most safe haven assets – US Treasury bonds, Japanese government bonds (JGBs) and gold also rallied.

But the move in bunds was particularly eye-catching, not least because 10-year yields are below their JGB equivalents.

Nor is the German bond market’s strength just a recent phenomenon. During the past decade, 10-year bunds have generated annual returns of around 6 per cent, while 30-year bonds have delivered 11 per cent, against around 10 per cent returns from the German equity market.

All of which makes it unsurprising that investors are increasingly wondering whether bunds have turned Japanese, a crucial question when one considers that over the past 30 years Japanese bonds have outperformed Japanese equities by more than 4 per cent a year, for a cumulative 250 per cent.

Japan’s decades of lacklustre growth, chronic deflation and policymakers’ efforts at jump-starting the economy with quantitative easing underpinned domestic demand for its bonds.

crossing over

10-year German and Japanese government bond yields, %

10-year German and Japanese government bond yields
Source: Bloomberg. Data covers 01.01.1990 - 31.05.2019 

But Germany is very different from Japan of the 1990s. It hasn’t seen a bubble in either financial markets nor property prices; its exchange rate is not overvalued; Germany’s bank lending growth is running at a respectable pace of more than 3 per cent, as opposed to Japan’s which contracted by 30 per cent over the decade to 2005; Germany is experiencing 3 per cent wage inflation compared to Japan’s decade of deflating wages; and the necessity to preserve the monetary union has resulted in a very accommodative monetary policy for Germany. By the same token, though it’s hard to see where the next boost for bunds is likely to come from. The market doesn’t expect the European Central Bank to raise rates until 2022 at the earliest.

Bund yields have fallen not because of weak growth but because of a flight to safety from debt-ridden peripheral European economies. Indeed, that’s particularly relevant given that bond yields tend to move in line with nominal GDP growth over the long run. On that measure, bunds are trading at a record 3 percentage points below trend GDP growth, whereas until 2013, JGB yields were above Japan’s growth rate.

It’s true that there are some similarities Germany now with Japan of the 1990s – poor demographics; large current account surplus; the wrong economic paradigm (“fiscal brake” for Germany, “strong yen” for Japan); excess dependence on exports and too great a focus on producing cars and other capital goods. But they still do not justify how far bund yields have fallen.

As a result, bunds have become the most expensive of all major asset classes, with yields standing at 240 basis points below US Treasury bonds and 100 basis points below what appears justified by Germany’s nominal GDP growth. At the same time technicals show that bunds are significantly overbought based on reliable historic metrics. 

This is why our strategy unit is underweight euro zone government bonds and why it makes sense to look elsewhere for a fixed income allocation, including US Treasury bonds.