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Department of Economics Brown Bag with Cristina Checherita-Westphal, ECB Determinants of euro area bond spreads: Investigating Non-Linearities in the Pricing of Sovereign Risk
Abstract: This paper provides renewed evidence on the drivers of 10-year government bond yield spreads across euro area countries after the sovereign debt crisis. Its focus lies in exploring non-linearities with respect to fiscal fundamentals and their interaction with other economic or financial indicators — such as the debt ownership structure — that may give rise to stress amplification channels. Employing threshold and smooth transition frameworks, we find amplification effects at higher debt levels, with thresholds around 90-110 percent of GDP and stronger effects thereafter. Across our models, the macro-fiscal fundamentals and political stability block has the largest explanatory power (roughly 40-60%), followed by monetary policy and investor base (33-50%). The explanatory power of fiscal fundamentals increases substantially in the non-linear models (up to 27%). The amplifications are not contained to macro-fiscal fundamentals, with liquidity constraints and debt ownership structure also being sensitively priced for high debt countries.