Convergence and Anchoring of Yield Curves in the Euro Area

1
Convergence and Anchoring of Yield Curves in the
Euro Area
Michael Ehrmann European Central Bank
Marcel Fratzscher European Central Bank
Eric T. Swanson Federal Reserve Bank of San
Francisco
Refet Gürkaynak Bilkent University
Conference on International Financial
Integration Federal Reserve Bank of
Atlanta November 30, 2007
Note The views expressed in this presentation
are the authors and do not necessarily reflect
the views of the management of the Federal
Reserve Bank of San Francisco or the European
Central Bank.
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European Monetary Union Background
Feb 1992 Maastricht Treaty signed Sep 1992
ERM crisis, several countries abandon exchange
rate pegs May 1998 Countries eligible for EMU
are announced Jan 1, 1999 Exchange rates
irrevocably fixed, European Central Bank
established, financial institutions adopt
euro Jan 1, 2002 Euro adoption completed,
currency issued
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Overview of the Paper

• Two related issues
• Convergence of sovereign bond yields (market
  integration)
• Convergence and anchoring of inflation
  expectations
• Despite unified monetary policy, convergence in
  these respects is not clear
• Bond market unification
• Default risk varies across sovereign governments
• Liquidity varies across bond issues
• Long-term inflation expectations
• There may be probability of exit from EMU

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Overview of the Paper

• Three metrics for assessing convergence
• Yield levels
• Yield volatility
• Yield sensitivity to news (conditional
  volatility)
• Focus on daily frequency bond market data
• More stringent test of convergence/unification/anc
  horing
• Two types of yields
• Medium- and long-term yields (bond market
  integration)
• Far-ahead forward interest rates (inflation
  expectations)

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Related Literature

• Studies of EMU on financial markets using monthly
  data
• Beale, Ferrando, Hördahl, Krylova, and Monnet
  (2004)
• Manganelli and Wolswijk (2007)
• Analysis of EMU on macroeconomic convergence
• Canova, Ciccarelli, Ortega (2006)
• Rogers (2007)
• Analyses using high-frequency data
• long-term inflation expectations Gürkaynak,
  Sack, and Swanson (2005), Gürkaynak, Levin, and
  Swanson (2007)
• effects of U.S. announcements on euro yields
  Ehrmann and Fratzscher (2006), Ehrmann,
  Fratzscher, and Rigobon (2006), Goldberg and
  Klein (2007)

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Data

• Daily bond yields for four largest euro area
  countries
• Germany
• France
• Italy
• Spain
• Also consider one control (non-euro area)
  country
• United Kingdom
• Sample periods
• pre-EMU 1993-1998
• post-EMU 2002-2006
• For comparability across countries, use
  zero-coupon yields

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Data Yield Curve Estimation
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Convergence of Yields Levels

• Convergence takes place even before EMU
• UK exhibits little convergence relative to EMU
  countries

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Convergence of Yields Volatility
Table 4 Principal Components Analysis of 2-year
Yields across Countries
sample sample
contribution of pre-EMU post-EMU
first PC .895 .998
second PC .097 .001
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Convergence of Yields Sensitivity
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Convergence of Yields Sensitivity
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Convergence of Yields Sensitivity
Figure 3 Response of 2-year Yield to
Macroeconomic Surprises
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Convergence of Yields Sensitivity
Figure 4 Heterogeneity in the Effects of
Macroeconomic Surprises
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Long-Term Yields and Inflation Expectations

• Long-term bond yields not necessarily a good
  measure of inflation expectations
• In response to a shock, short-term interest rates
  move
• Long-term yields are an average of the short-term
  rates over the life of the bond
• Long-term yields should exhibit some sensitivity
  to news

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Long-Term Yields and Inflation Expectations
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Far-Ahead Forward Rates
To study anchoring of inflation expectations, it
is better to use forward interest rates rather
than long-term rates
For N large enough, we have
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Far-Ahead Forward Rates
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Far-Ahead Forward Rates
Figure 5 Response of 9-year-ahead 1-year Forward
Rate to Macroeconomic Surprises
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Far-Ahead Forward Rates
Figure 6 Heterogeneity in the Effects of
Macroeconomic Surprises on the 9-year-ahead
1-year Forward Rate
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Conclusions

• European Monetary Union appears to have led to a
  unified sovereign bond market, despite
  differences in liquidity and default
  probabilities across member countries
• Convergence in yield levels, volatility, and
  sensitivity to news
• Convergence in daily data as well as at lower
  frequency
• Evidence that EMU has led to convergence in
  long-term inflation expectations
• Inflation expectations in Italy and Spain seem to
  have benefited the most