Interest Rate Differentials and Monetary Policy in the European Monetary Union: The Case of 10 and 30 Year Bonds

Abstract

This empirical study uses techniques of time series analysis to examine how government bond yield spreads in France, Italy and Spain (relative to Germany) react to central bank actions in the European Monetary Union. More specifically, fixed income securities with maturities of 10 and 30 years are considered. These long term bonds should be of special importance for the European life insurance industry because of the liability structure of these financial services firms. Other central banks already have hiked interest rates and financial markets, as a consequence, now financial markets seem to be waiting for an increase to the Main Refinancing Operations Announcement Rate. Six bivariate VAR models are estimated. Our results imply that in general there is no strong positive reaction of the bond yield spreads to a contractionary monetary policy shock. Furthermore, there seems to be a negative reaction of the monetary policy rate to a positive shock to the government bond yield spread in the first months. In some cases (10 year bonds of France and Italy) this empirical finding is statistically significant. Therefore, the empirical evidence reported here is not only interesting from the viewpoint of economic theory but also has practical implications for asset managers in the European insurance industry.