The first conclusion is that the common factor of public debt supplies (the global trend) is significant (with a lag of four quarters) for all countries in explaining sovereign spreads, with higher beta for the European periphery. An acceleration in the common factor of public debt supplies triggers a widening of spreads one year later. The EMU periphery countries tend to be more sensitive to this common factor (they have a higher beta) and therefore the exposure of those countries to a risk of generalized complacency is higher (Table 1). This feature is reminiscent of the sovereign debt crisis in 2012-2013, which took place a few years after the implementation of large synchronized fiscal impulses in response to the Great Financial Crisis. With regard to the EU recovery fund, this also means that issuing common public debt does not necessarily immunize sovereign spreads from episodes of stress and widening a few quarters later. Accordingly, the ECB is likely to have to continue acquiring large swaths of European sovereign bonds to avoid any significant widening of spreads leading to new doubts about the Eurozone’s fragmentation.
The second conclusion we draw is that the U.S. 10-year interest rate has a higher impact on European spreads than national specific factors of debt. Coefficients attached to this factor are negative. This could mirror a smoothing or shock-absorbing function of the world’s most important central banks (the Fed and other central banks that are followers), stabilizing the market when spreads become overly volatile by outright intervention of securities purchases. In this configuration, U.S. rates reflect the stance of the major central banks in stabilizing monetary and financial conditions. Lower U.S. interest rates result from high global risk-aversion and fragile market liquidity, an environment where spreads tend to widen. This suggests that the ECB, could have to intervene in an asymmetric manner, compared with the Fed, should the European spreads widen while the US central bank is engaged in a phase of monetary policy normalization.
The third conclusion is that specific factors of the U.S. and Germany’s public debt supply are strongly significant in explaining all EMU sovereign spreads. We could call that the safe heaven signal effect. Therefore, any deviation from the global trend of public debt issuance by the U.S. or Germany has a significant impact on European spreads. This shows how dependent fragile economies are upon the benchmark markets. The main risk for them stems from a possible austerity shock in Germany and/or the U.S. This could trigger another episode of stress in the EMU sovereign debt market. This means that by implementing a more conservative fiscal policy compared to the common trend,
the U.S. and
Germany could trigger a widening of EMU sovereign spreads (national specific factors are negatively correlated with the common factor).
Finally yet importantly, specific factors of periphery countries’ public debt have a low explanatory power (are not significant for the Spanish and Portuguese cases) in explaining spreads, meaning that those countries could face high difficulties in stabilizing their government bond yields even when being determined to stabilize public debt. We call that the diluted signal effect of debt policy. When looking at the share of variance explained by country-specific debt supply (Table 2), we realize that the common factor of debt supply, and above all the U.S. 10-year interest rate, have a much higher explanatory power with regard to sovereign spreads. This means that EMU countries are not fully in control of their destiny when trying to implement asymmetric fiscal policies in order to influence sovereign spreads.
Table 2 – Explanatory power of factors (variation in R2 when integrating the variable)