Similarities between the euro
region and Japan are intensifying, heaping pressure on Mario Draghi while offering good news for bond holders.

Sluggish credit growth? Check. Slowing economy? Check.
Falling market expectations for inflation? Check. Aging
population? Yes, it has that too, placing Europe in a similar
situation to what was encountered by the world’s third-largest
economy after the bubble burst on its postwar Economic Miracle.

That’s a concern for DZ Bank AG, the most bullish
forecaster of German bunds in data compiled by Bloomberg. It
estimates the 10-year yields will fall to a euro-era record of
0.5 percent by the first quarter, leaving them below the 0.65
percent median estimate for their Japanese peers.

With the official interest rate near zero, European Central
Bank President Draghi may need to do more to steer the region
away from the deflation and debt traps that condemned Japan to
two decades of stagnation.

“Renewed ECB activism offers hope that the euro area will
not follow the path Japan embarked on in the 1990s,” said
Nikolaos Panigirtzoglou, London-based global market strategist
at JPMorgan Chase Co. (JPM) “Low growth leads to low income growth.
Combine that with persistently high unemployment and you’ve got
a lack of confidence.”

Europe should be on a roll. It’s never been cheaper for
euro-area governments or individuals to borrow money and the ECB
is seeking to put cash into the economy through cheap loans to
banks and a pledge to buy asset-backed securities.

Bund Yields

The rate on benchmark German bunds was at 0.98 percent as
of 10:40 a.m. London time and touched a record 0.866 percent
last month. Spanish yields fell to 2.039 percent earlier this
month, from 7.751 percent just before Draghi boosted confidence
in the region with a pledge in July 2012 to do “whatever it
takes” to save the euro. This month, the ECB lowered the main
interest rate to 0.05 percent. Officials are forecast to keep
the rate unchanged in their next policy decision on Oct. 2.

Yet there is little evidence any benefits are feeding
through to the economy.

Euro-area growth stagnated in the second quarter and data
today showed inflation slowed to 0.3 percent this month, a
fraction of the ECB’s goal of just under 2 percent. The central
bank’s preferred measure of medium-term inflation expectations
is near a four-year low.

Declining Costs

Although declining costs for everything from transport and
food to clothes can be good news for consumers, disinflation —
or slowing inflation — makes it harder for borrowers to pay off
debts and for businesses to boost profits. Under deflation, or
falling prices, households may postpone purchases and companies
may delay investment and hiring as demand for their products
dries up.

“The euro region is at this very moment in a quite similar
situation as Japan although certain dynamics may be different,”
saidHendrik Lodde, a strategist at Frankfurt-based DZ Bank.
“While we don’t expect outright deflation for the euro zone,
the economy is likely to continue to face some strong
headwinds.”

Bubble Burst

Since Japan’s real estate and stock market bubble burst in
the early 1990s, companies have focused on cutting debt and
shifting manufacturing overseas. Wages stagnated and consumers
reined in spending. That led to two decades with no nominal
growth in the economy. Prices of goods kept falling, creating
deflation that sapped optimism.

Euro-region inflation expectations, as measured by five-year consumer-price swaps, have fallen and stayed below those of
Japan since March this year. M3 money supply, a broad measure of
liquidity, grew 2 percent in August. That’s less than half the
average of 5 percent in the past 10 years, and below the 4
percent threshold that characterized the Japanese deflation
experience in the past two decades, according to JPMorgan.

Adding to the mix of constrained credit conditions, a high
level of debt and low growth in Europe, a fifth of German,
Italian, and Greek people are older than 65, up from around 15
percent in 1991, according to the U.S. Census Bureau. Japan has
the biggest proportion of older people, with those over 65
accounting for 25 percent of its population.

Shifting demographics mean more consumers in these
countries will no longer be producers, placing further headwinds
on growth.

Similar Symptoms

While the causes of the problems in the euro area and Japan
may not be exactly the same, the symptoms are similar and
require further action from policy makers, said DZ Bank’s Lodde,
whose forecast for German bund yields was the lowest among 21
analysts in a Bloomberg survey.

He forecasts the ECB will start buying sovereign bonds
early next year to further stimulate the economy.

“We have reached the point in Europe where investors
cannot even begin to imagine a point where interest rates will
start rising again, and that’s a Japanization dynamic from our
perspective,” Mark Dowding, co-head of investment-grade bonds
and partner at BlueBay Asset Management LLP, which oversees $58
billion, said in a phone interview on Sept 24. “The economy is
crying out for much easier policy and the ECB will need to do
more.”

Bond Purchases

Dowding predicts that the central bank will start buying
sovereign bonds under its quantitative easing program as early
as the first quarter of next year as purchases of asset-backed
securities alone won’t be enough to stimulate the faltering
economy.

The extra yield investors get for holding 10-year German
bunds instead of similar-maturity Japanese government bonds was
at 45 basis points today, within 10 basis points of the euro-era
low of 35 basis points reached in June 2012. The average since
the euro was introduced in 1999 was 220 basis points.

“We are in an environment where the German bund is the
dark star that will shrink towards the point of singularity and
exert a gravitational pull on all other assets in the
universe,” said Dowding. “That will effectively pull spreads
tighter as a result of low bund yields.”

To contact the reporter on this story:
Anchalee Worrachate in London at
aworrachate@bloomberg.net

To contact the editors responsible for this story:
Paul Dobson at
pdobson2@bloomberg.net
Mark McCord