Analysts are increasingly comparing Europe to Japan, which has struggled unsuccessfully with deflation and a stronger yen since the 1990s. Are they right and how will this affect financial markets?

The yield on ten-year bonds in Spain and Italy has come very close to the yield on US government bonds. Irish securities are already more expensive; their spread to Portuguese ones is less than 1%. Greek bond yields are at five-year lows. There is an orgy on the corporate paper market in Europe, investors are sweeping away bonds, despite the fact that many issuers are trading at higher prices than the corresponding sovereign bonds.

What's happening? Inflation expectations in Europe have been falling since last autumn, and the ECB predicts that inflation will not exceed 0.8% in 2014. Analysts are increasingly comparing Europe to Japan, which has struggled to combat long-term deflation and a stronger yen since the 1990s. Are they right and how will this affect financial markets?

At the European Central Bank's June meeting, Mario Draghi proposed a wide range of stimulus measures, including a cut in the official policy rate, a negative deposit rate and a $400 billion refinancing program (TLTRO) aimed at boosting lending to real businesses.

Will these measures help fight the specter of deflation? Hardly.

Short-term interest rates in the eurozone fell to 0.10–0.15% back in 2013, so the recent rate cuts are more of a symbolic nature. As for the lending program, as the experience of Japan and the United States shows, after a large-scale crisis, companies for many years are exclusively engaged in paying off existing debts, despite super-low rates. The only force that can send them back to the bank for a loan is a few years of sustained economic growth. It is clear that in Europe, which has barely emerged from the second wave of recession, it is too early to talk about high growth rates.

However, it is not a fact that European banks will accept TLTRO with enthusiasm. Most banks are already not experiencing any problems with liquidity and are repaying the ECB loans received under the previous LTRO program ahead of schedule. Strictly speaking, even now there are no obstacles to expanding lending. However, banks are more concerned about the capital they need to raise under new banking regulations. From this point of view, they are not only not interested in increasing the loan portfolio, but are also not against reducing the existing one. It's no surprise that lending in Europe has fallen for the fifth year in a row.

The recent experience of Great Britain leaves little hope of reversing the unpleasant trend using purely monetary tricks. After the introduction of a similar program (Funding for Lending), the bulk of the money went not to the real economy, but to the London real estate market. Japan has been trying unsuccessfully to overcome a “balance sheet recession” since the 1990s: regardless of the attractiveness and variety of incentives, corporations are reluctant to take on debt.

A new surge of deflationary fears in Europe is a matter of time.

There is a high probability that the ECB will have to resort to a “quantitative easing” program. However, even if this does not happen, with falling inflation, yields will continue to decline. Just look at the Japanese 10-year bond, trading today with a yield of just 0.6%!

If buying European bonds does not seem attractive, then you can look at stocks from a different angle. According to Bank Credit Analyst, in countries where inflation disappears, the structure of income in the stock market changes. The main profit comes from dividend growth, not price changes, and the dividend yield significantly exceeds the yield on government securities. For example, in Japan and Switzerland, where there has been practically no inflation for 20 years, dividend yields exceed bond yields by 3 and 4.5 times, respectively. It is likely that those eurozone countries where deflationary tendencies are strongest will also come to this conclusion. Already, the dividend yield of the Spanish market is 4.5%, while the 10-year bond yield is only 2.7%. Not bad for a bet in euros.

In addition, the ECB's actions are likely to strengthen the local currency, supporting the investment attractiveness of euro assets. The eurozone balance of payments surplus reached a record €400 billion at the beginning of 2014. At the same time, central banks have not made euro purchases since 2010. What will happen to the euro exchange rate and assets when the fashion for diversifying gold and foreign exchange reserves returns?

Bad without inflation: how the EU economy is similar to the Japanese one