Abstract
Previous work has documented a greater sensitivity of long-term government bond yields to fundamentals in Euro area stress countries during the euro crisis, but we know little about the driver(s) of regimeswitches. Our estimates based on a panel smooth threshold regression model quantify and explain them: 1) investors have penalized a deterioration of fundamentals more strongly from 2010 to 2012; 2) a key indicator of regime switch is the premium of the financial credit default swap index: the higher the bank credit risk, the higher the extra premium on fundamentals; 3) after ECB President Draghi’s speech in July 2012, it took one year to restore the non-crisis regime and suppress the extra premium. JEL Classification: E44, F34, G12, H63, C23
Highlights
Financial market participants have a particular taste for locutions that describe the dynamics of asset prices
Our model predicts that investors price the sovereign risk differently when the banking credit default swap (CDS) index is over 130.7 bp, a value which was crossed in autumn 2010 shortly after
Our panel smooth transition regression (PSTR) estimations confirm the previous finding that the changing sensitivity of bond yields to fundamentals is necessary to explain yields during the crisis period (Aizenman et al (2013) and Afonso et al (2015))
Summary
Financial market participants have a particular taste for locutions that describe the dynamics of asset prices. A way to picture these comments is to say that sovereign risk pricing is regime-dependent and subject to threshold effects. We integrate these different pieces by exploring the possibility that the switch to the crisis regime was triggered by the deterioration of the banks’ risk, the liquidity spirals, or both: two endogenous mechanisms potentially implying self-amplifying dynamics. We control for alternative mechanisms, such as the rise of systemic risk in the market and the rise of volatility on several market segments.
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