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Both the US Federal Reserve and the ECB are evaluating how to conduct monetary policy in a world of persistently low – and below-target – inflation where economies suffer from, or risk becoming the object of, Japanification. Such a vicious economic circle is marked by high debt, low growth, low interest rates, and low inflation.

Following in Japan’s – low growth, low inflation – footsteps?

At first blush, the situation in Japan – the origin of the label – does seem dire: average real GDP growth stands at just 0.9% a year over the last two decades, the population is in decline, and the ratio of workers to retirees is deteriorating. Japanese government bonds have returned just 1.8% over the last 20 years compared to 5.2% for the Bloomberg Barclays Global Aggregate ex-Japan bond index. Equities have lagged by a similar amount.

By other measures, things look brighter. While debt is high, low interest rates mean that the debt burden is low and with the bulk of debt held domestically, it is unlikely that a loss of investor confidence would hit the yen. At 2.2%, the unemployment rate is below that even in the US.

Japan’s GDP growth is inevitably lower than in countries with rising populations, but relative to the number of people in the country, Japan’s performance is strikingly good. GDP per capita growth has until just recently outpaced that of the US and is easily faster that of the eurozone (see Exhibit 1).

Exhibit 1: Japan is ahead in terms of GDP per capita

Real GDP, in local currency terms; 2009 = 100

macroeconomic GDP FI 1

Data as at 3 January 2020. Source: Haver, BNP Paribas Asset Management

Even if Japan’s situation is not as bad as assumed, central bankers would still rather have higher inflation and higher interest rates to have greater scope for cutting rates to offset an economic slowdown.

How effective can central bankers be in the hunt for inflation?

The Bank of Japan set a 2% inflation target in 2013 and then, alongside negative interest rates and yield-curve control in 2016, announced it intended to overshoot it consistently. Effective?

On one hand, the BoJ has had some success. Between the end of 2012 and now, core inflation has risen by nearly 90bp. US inflation is 40bp higher, while the eurozone rate is 35bp lower. For Japan and the US, core inflation is now above the average of the 10 years before the global financial crisis (see Exhibit 2).

Exhibit 2: Core inflation rates

All items less food and energy; dashed line is 10-year, pre-GFC average

macroeconomic inflation FI 2

Data as at 3 January 2020. Source: Haver, BNP Paribas Asset Management

Markets are unconvinced, however, that the central banks will ultimately succeed in meeting their inflation targets. Even as core inflation in Japan and the US has slowly recovered, inflation expectations have continued to fall. They are currently only slightly above their all-time lows.

Given rising technological disinflationary headwinds (e-commerce, sharing apps, etc.), the task ahead for central banks is large. Success by no means guaranteed.

US yields: at the mercy of external events?

With steady economic growth, stable policy rates, and subdued inflation expectations, we expect 10-year US Treasury yields to range between 1.6% and 2.0% this year. Even with the unemployment rate at its lowest since 1969, wage inflation is decelerating.

The Fed is unlikely to change interest rates until after the US presidential election as GDP growth slows to trend, even though further cuts are arguably needed given that inflation is still below target.

While there could be further fiscal stimulus if not only president Trump wins re-election, but the Republicans to retake control of the House of Representatives, we believe the more likely outcome is a divided Congress, limiting the scope for significant spending, borrowing or taxation shifts.

As a result, Treasury yields are likely to be most sensitive to geopolitical events, from trade tensions with China to events in the Middle East.

Eurozone yields: the promise of the ‘periphery’

We expect equally little change in monetary policy. Much attention will likely be paid to Sweden, which has led the way out of negative interest rates. Growth and inflation trends will tell policymakers whether the benefits of non-negative rates would outweigh what could appear as a tightening in monetary policy. However, the ECB’s pledge not to raise rates until after QE has ended ties its hands.

Consequently, the yield on much of the core government debt is likely to remain negative.

Investing in ‘peripheral’ market bonds would be one of the few options to earn (barely) positive total returns in 2020. The most obvious investment risk is Italy. Elections could return the Lega party to power, sparking a renewed widening in Italian government bond spreads.


video Dominik DeAlto Investment Forum 2019

Also watch Low interest rates in 2020 and beyond, a video with Dominik DeAlto, CIO Global Fixed Income. He comments on investors still seeking higher-yielding asset classes and singles out corporate bonds, structured securities and other spread products as appealing opportunities. He favours a long risk, long duration position to have exposure to falling interest rates.

Watch the video


This is an extract from our fixed income outlook for the first quarter of 2020

This article appeared in The Intelligence Report

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