In retrospect, it is striking that the sovereign bond spreads of peripheral Eurozone countries surged while the economic conditions were gradually deteriorating. This column provides a new explanation for this phenomenon. It suggests that the markets in credit default swap indices have exacerbated shocks to economic fundamentals. The same change in fundamentals had a higher impact on the spread during the crisis period than it had previously.
The job of government bond analysts has been tough since the Eurozone crisis started. They’ve had to tell their clients a story behind every single bond spread hike since the fall of 2009. The list includes concerns over peripheral sovereigns’ public finances, deterioration of the fundamentals, financial sector credit risk, and European institutional coordination failures.
In retrospect, however, it is striking that aside from Greece, the sharp rise of peripheral sovereign bond spreads and their volatility is hard to reconcile with the underlying economic fundamentals. Spreads surged suddenly, while the economic conditions were deteriorating gradually.
- In Spain, for example, the public debt amounted to less than 60% of GDP even by end-2009.
- The Italian primary fiscal surplus implied that if interest rates had stayed low, only modest fiscal adjustment would have been necessary to service the debt.
Even invoking a broader set of news seems insufficient to explain the sudden eruption of the crisis. Unemployment and trade deficits had been increasing gradually. Weaknesses in the banking sector also appeared only gradually after the burst of property bubbles.
Non-fundamental factors
This suggests that some non-fundamental factor exacerbated shocks to economic fundamentals of peripheral European countries. That is, the same change in a fundamental may have had a higher impact on the spread in the crisis period than it had previously.
Previous research describes two different regimes, crisis and non-crisis, with additional fundamental factors important in the crisis regime (Aizenman et al. 2011, Gerlach et al. 2010, Montfort and Renne 2012, Favero and Missale 2011). These papers usually attribute nonlinearities to the fiscal situation. They find that yield spreads have become much more sensitive to fiscal imbalances after 2008, with a deterioration of fiscal indicators generating a significant widening of the spreads after 2008. But the crisis may have other than fiscal roots. Attributing amplification dynamics only to fiscal imbalances – an exogenous driver – is questionable in the light of recent advances in the study of financial market dynamics.
