European Government Borrowing Costs Are Plunging — And It's All Thanks To Japan

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Government borrowing costs – as measured by 10-year sovereign bond yields – are hitting record lows across the euro zone "core" today.

In France, 10-year yields have fallen to 1.75 percent. The Belgian 10-year is at 1.95 percent, the Dutch 10-year is at 1.62 percent, and the Austrian 10-year is at 1.49 percent.

Matthew Boesler/Business Insider, data from Bloomberg

European leaders will be quick to take the credit. Economic austerity for troubled economies in the euro area periphery in need of financial assistance is still the main agenda. The idea is that markets reward the countries willing to undertake painful austerity measures with lower borrowing costs.

Linking austerity measures to lower borrowing costs, however, is a bit of a shaky exercise, as Pawel Morski points out. After all, the French economy is enduring a deepening recession, and the others are stumbling as well. A much simpler explanation for the steady march lower in euro zone bond yields is the introduction of monetary measures by the ECB last summer to pacify markets.

And the driver cited by many analysts for this latest move lower in French, Belgian, Dutch, and Austrian borrowing costs in recent weeks, sending them to record lows, is renewed interest in those bonds from Japanese institutional investors, like life insurers.

In Japan, new stimulus measures designed to weaken the yen are sending Japanese government bond yields lower, forcing Japanese institutions to go elsewhere for interest income.

"If Japanese institutional [investors] are under pressure because of the collapse in yields at the
long-end of the Japanese curve, we may begin to see a wave of unhedged global yield buying," says Citi analyst Steven Englander.

According to Morgan Stanley analysts Elaine Lin and Maggie Chidothe, there are two big groups of Japanese investors driving the flows: life insurance companies and banks.

In a note to clients, Lin and Chidothe write:

Life insurance companies: Japanese lifers are heavily exposed to long-dated Japanese government bonds; their investment decisions will be affected the most by the Bank of Japan’s action. They have cut their exposures to peripheral sovereigns (Italy and Spain) at the height of the sovereign crisis. Appetite for peripheral sovereigns is likely to be dependent on the sovereign crisis outlook. However, for large core countries (Germany and France), there is potential for marginal demand given lower Japanese government bond yields. In particular, this could benefit demand for [French] OATs, given the more attractive yields compared to Germany. 

Banks: Japanese banks are the major investors in European government bonds  among the Japanese investor base. They have been increasing their exposure in European sovereigns since 2012, in particular via France, while maintaining a stable exposure to peripherals (Exhibit S3). This trend may continue given the outlook for a weaker yen . However, it is worth noting that Japanese banks are not heavily exposed to long-dated Japanese government bonds, so banks will be less affected by lower long-dated Japanese government bond yields and diversification needs may be less meaningful.

The charts below show how European government bonds – especially French bonds – have benefitted from Japanese bank buying.

BIS, Morgan Stanley Research


"The likely increased demand for [French] OATs has already been priced into the market following the Bank of Japan meeting, with France significantly outperforming all other European government bonds since Thursday," say the Morgan Stanley analysts. "The initial move may have been exaggerated by the strong [French] OAT auction."

If Japanese markets continue trending in the same directions they are now on the back of strong monetary stimulus from the Bank of Japan, this dynamic could continue to support euro zone bond markets. However, it will have nothing to do with successful implementation of austerity measures or growing economies in the euro zone's "core" countries.



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