The importance of expectations in determining sovereign spreads

Abstract

This paper investigates how changes in expectations regarding the ability of the European Monetary Union to address the debt crisis have asymmetrically impacted the cost of sovereign borrowing in central and peripheral European countries. It shows that most of the variations in sovereign spreads can be explained by fundamentals in a model that allows for structural breaks. We test for both the presence and the time of structural breaks, deriving their asymptotic distribution and confidence intervals. The two estimated breakpoints are: the second quarter of 2010, a period when financial markets lacked confidence in a resolution for the crisis; and the third quarter of 2010, when financial markets regained confidence following Mario Draghi's ‘whatever it takes’ announcement. Market fears, measured by the degree of international risk aversion, became more important to price sovereign debt only for peripheral economies during the crisis.