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Do German bonds face Japanification?

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The euro zone's long disinflation has spurred fears it will tumble all the way to Japan-style deflation, with some concerned yields on the continent's safe-haven bond, the German bund, could remain depressed for the long haul.

"While we are still not convinced that the euro zone is the new Japan, despite the many similarities in their economic predicaments, we are increasingly of the view that the 10-year Bund yield will remain exceptionally low for at least the next couple of years," John Higgins, chief markets economist at Capital Economics, said in a note Wednesday.

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The 10-year bund is yielding around 0.75 percent, around all-time lows, compared with the 10-year Japanese government bond (JGB) at around 0.45 percent after a decades-long downtrend.

Japan's central bank cut its benchmark interest rate to 0.5 percent in 1995, a move that pushed the 10-year JGB yield below 1 percent after three years, Higgins noted.

"Investors did not know in 1998 that Japan's key policy rate would remain near zero for the next 16 years (and counting). But the prospect of it remaining there for the foreseeable future was enough to keep the 10-year yield quite firmly anchored," he said. "We see no reason why a similar outcome couldn't happen in Germany," as the bund yield fell below 1 percent after the European Central Bank (ECB) cut its main rate to 0.5 percent in mid-2013.

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Capital Economics cut its end-2014 and end-2015 forecasts for the bund yield by 25 basis points each to 0.75 percent and 1.0 percent respectively. It also cut its end-2016 bund yield forecast to 1.00 percent from 1.50 percent.

Japanification

It's not just government bond yields that are spurring concerns the euro zone faces "Japanification."

In the third quarter, euro zone gross domestic product (GDP) grew by 0.2 percent on the previous quarter, with regional economic powerhouse Germany narrowly avoiding a recession. In October, the region's inflation was 0.4 percent on-year, doing little to assuage deflation fears.

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"We think growth will be too weak to trigger tighter monetary policy. This has been the case in Japan," Higgins said, noting GDP there has grown only by an average 0.7 percent annually since the Bank of Japan cut its rate to 0.5 percent in 1995.

In the third quarter, Japan slid into recession, with its GDP contracting 1.6 percent on-year after the second quarter's 7.1 percent drop.


Others are also concerned that Europe's government bonds could go the way of Japan.

"European bond markets have followed Japan's deflation script," Barclays said in a note Monday. "If anything, euro bonds have priced these deflation concerns more quickly," it added, noting the euro zone has yet to actually experience deflation.

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To be sure, many point toward an expected increase in U.S. interest rates sometime in 2015 as helping to reverse the drop in bund yields.

"Rises in U.S. interest rates could encourage European and international investors to re-balance their portfolios in favor of U.S. debt at the expense of European bonds," Moody's said in its global sovereign bond outlook Tuesday.

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Capital Economics' Higgins also expects rising U.S. interest rates would help to boost the 10-year bund yield as the two have tracked each other in the past. But he noted that the spread between the two yields is already at its largest since the start of the European monetary union.

"We see no reason why it should not grow further as the contrast between the monetary policies of the Fed and the ECB becomes increasingly stark," Higgins said.

—By CNBC.Com's Leslie Shaffer; Follow her on Twitter @LeslieShaffer1