Political Uncertainty and Sovereign Bond Markets

Abstract

This paper analyzes the effects of political uncertainty on prices and liquidity of sovereign bonds. We focus on the time period of the European sovereign debt crisis and on Italian government bonds. We study the effect of Euro, G8 and G20 summits together with relevant elections. Focusing on Italy allows us to analyze a major European government bond market based on detailed transaction data, which was highly affected by the sovereign debt crisis. In line with the theoretical literature, we find a significant drop in prices in combination with high illiquidity and sell-side pressure before the event. Prices and trading activity start to recover approximately one month after the event when the impact uncertainty of policy changes resolves. The effects are stronger when uncertainty - measured by the EPU index - is high and the economic conditions are perceived as being weak.