Abstract
We revisit the discussion of market sentiment in European sovereign bonds using a correlation analysis toolkit based on influence networks and hierarchical clustering. We focus on three case studies of political interest. In the case of the 2016 Brexit referendum, the market showed negative correlations between core and periphery only in the week before the referendum. Before the French presidential elections in 2017, the French bond spread widened together with the estimated Le Pen election probability, but the position of French bonds in the correlation blocks did not weaken. In summer 2018, during the budget negotiations within the new Italian coalition, the Italian bonds reacted very sensitively to changing political messages but did not show contagion risk to Spain or Portugal for several months. The situation changed during the week from October 22 to 26, as a spillover pattern of negative sentiment also to the other peripheral countries emerged.
Highlights
In this empirical study, we discuss the short-term impact of three specific political situations relevant to the European Union on the return correlations between its sovereign bond markets in 2016, 2017, and 2018
We focus on effects happening at the same time in these markets and interpret the correlation patterns on an hourly timescale in non-overlapping weekly time windows as an expression of the sentiment of market makers regarding a potential risk spillover
To illustrate our interpretation of “sentiment,” we point out that positioning decisions of large investors happen at a slower pace than quote changes generated by quote machines of bond market makers
Summary
We discuss the short-term impact of three specific political situations relevant to the European Union on the return correlations between its sovereign bond markets in 2016, 2017, and 2018. The three political situations in Europe relevant for bond markets that gained the most public interest after 2015 were the 2016 Brexit referendum, the 2017 French presidential elections, and the 2018 Italian budget negotiations. In. contrast to the standard portfolio management literature, negative correlations are not an opportunity for diversification, but a warning signal in the specific case of this dataset as they appear between Euro area sovereign bonds that should be benchmark instruments without default risk. This ordering may depend on subjective beliefs or a market practice to sort issuers into a tiered hierarchy
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