Convergence and Anchoring of Yield Curves in the Euro Area Conference on International Financial Integration Federal Reserve Bank of Atlanta November 30,

Convergence and Anchoring of Yield Curves in the Euro Area

Conference on International Financial IntegrationFederal Reserve Bank of Atlanta

November 30, 2007

Michael EhrmannEuropean Central Bank

Note: The views expressed in this presentation are the authors’ and do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco or the European Central Bank.

Marcel FratzscherEuropean Central Bank

Refet GürkaynakBilkent University

Eric T. SwansonFederal Reserve Bank of San Francisco

Feb 1992: Maastricht Treaty signed

Sep 1992: ERM crisis, several countries abandon exchange rate pegs

May 1998: Countries eligible for EMU are announced

Jan 1, 1999: Exchange rates irrevocably fixed, European Central Bank established, financial institutions adopt euro

Jan 1, 2002: Euro adoption completed, currency issued

European Monetary Union: Background

Two related issues:

• Convergence of sovereign bond yields (market integration)

• Convergence and anchoring of inflation expectations

Despite unified monetary policy, convergence in these respects is not clear:

• Bond market unification:• Default risk varies across sovereign governments• Liquidity varies across bond issues

• Long-term inflation expectations:

• There may be probability of exit from EMU

Overview of the Paper

Three metrics for assessing convergence:

• Yield levels

• Yield volatility

• Yield sensitivity to news (conditional volatility)

Focus on daily frequency bond market data

• More stringent test of convergence/unification/anchoring

Two types of yields:

• Medium- and long-term yields (bond market integration)

• Far-ahead forward interest rates (inflation expectations)

Overview of the Paper

Related Literature

Studies of EMU on financial markets using monthly data:• Beale, Ferrando, Hördahl, Krylova, and Monnet (2004)• Manganelli and Wolswijk (2007)

Analysis of EMU on macroeconomic convergence:• Canova, Ciccarelli, Ortega (2006)• Rogers (2007)

Analyses using high-frequency data:• long-term inflation expectations: Gürkaynak, Sack, and

Swanson (2005), Gürkaynak, Levin, and Swanson (2007)• effects of U.S. announcements on euro yields: Ehrmann

and Fratzscher (2006), Ehrmann, Fratzscher, and Rigobon (2006), Goldberg and Klein (2007)

Data

Daily bond yields for four largest euro area countries:• Germany• France• Italy• Spain

Also consider one “control” (non-euro area) country:• United Kingdom

Sample periods:• pre-EMU: 1993-1998• post-EMU: 2002-2006

For comparability across countries, use zero-coupon yields

Data: Yield Curve Estimation

Convergence of Yields: Levels

• Convergence takes place even before EMU

• UK exhibits little convergence relative to EMU countries

Convergence of Yields: Volatility

sample

contribution of: pre-EMU post-EMU

first PC .895 .998

second PC .097 .001

Table 4: Principal Components Analysis of 2-year Yields across Countries

Convergence of Yields: Sensitivity

Convergence of Yields: Sensitivity

Convergence of Yields: Sensitivity

-2-1

01

2

19941996 199820002002 20042006

.Non-farm payroll employment

0.5

11

.52

2.5

1994199619982000200220042006

.ISM - NAPM

-10

12

3

1994199619982000200220042006

.US inflation0

12

3

1994199619982000200220042006

.IFO confidence

-1.5

-1-.

50

.5

1994199619982000200220042006

.France inflation

01

23

4

1994199619982000200220042006

.Germany inflation

-.5

0.5

11

.5

1994199619982000200220042006

.Italy inflation

-2-1

01

2

1994199619982000200220042006

.Spain inflation

0.5

11

.51994199619982000200220042006

.Euro area M3

Figure 3: Response of 2-year Yield to Macroeconomic Surprises

Convergence of Yields: Sensitivity

.51

1.5

2

19941996 199820002002 20042006

.Non-farm payroll employment

.2.4

.6.8

1

1994199619982000200220042006

.ISM - NAPM

0.5

11

.52

1994199619982000200220042006

.US inflation.2

.4.6

.81

1994199619982000200220042006

.IFO confidence

0.5

11

.52

2.5

1994199619982000200220042006

.France inflation

0.5

11

.52

1994199619982000200220042006

.Germany inflation

0.2

.4.6

.8

1994199619982000200220042006

.Italy inflation

0.5

11

.5

1994199619982000200220042006

.Spain inflation

0.2

.4.6

.81

1994199619982000200220042006

.Euro area M3

Figure 4: Heterogeneity in the Effects of Macroeconomic Surprises

Long-Term Yields and Inflation Expectations

Long-term bond yields not necessarily a good measure of inflation expectations:

• In response to a shock, short-term interest rates move

• Long-term yields are an average of the short-term rates over the life of the bond

• Long-term yields should exhibit some sensitivity to news

Long-Term Yields and Inflation Expectations

Far-Ahead Forward Rates

To study anchoring of inflation expectations, it is better to use forward interest rates rather than long-term rates:

For N large enough, we have:

Far-Ahead Forward Rates

Far-Ahead Forward Rates

-10

-50

5

19941996 199820002002 20042006

.Non-farm payroll employment

-4-2

02

1994199619982000200220042006

.ISM - NAPM

-20

24

1994199619982000200220042006

.US inflation-1

01

23

1994199619982000200220042006

.IFO confidence

-10

12

34

1994199619982000200220042006

.France inflation

02

46

81

0

1994199619982000200220042006

.Germany inflation

-10

12

3

1994199619982000200220042006

.Italy inflation

-3-2

-10

12

1994199619982000200220042006

.Spain inflation

-2-1

01

21994199619982000200220042006

.Euro area M3

Figure 5: Response of 9-year-ahead 1-year Forward Rate to Macroeconomic Surprises

Far-Ahead Forward Rates

12

34

5.19941996 199820002002 20042006

.Non-farm payroll employment

.51

1.5

2.1994199619982000200220042006

.ISM - NAPM

.51

1.5

22

.5.

1994199619982000200220042006

.US inflation0

.51

1.5

2.

1994199619982000200220042006

.IFO confidence

02.

1994199619982000200220042006

.France inflation

01

23

45.

1994199619982000200220042006

.Germany inflation

.6.8

11

.21

.41

.6.

1994199619982000200220042006

.Italy inflation

0.5

11

.52.

1994199619982000200220042006

.Spain inflation

0.5

11

.5.1994199619982000200220042006

.Euro area M3

Figure 6: Heterogeneity in the Effects of Macroeconomic Surprises on the 9-year-ahead 1-year Forward Rate

Conclusions

• European Monetary Union appears to have led to a unified sovereign bond market, despite differences in liquidity and default probabilities across member countries

• Convergence in yield levels, volatility, and sensitivity to news

• Convergence in daily data as well as at lower frequency

• Evidence that EMU has led to convergence in long-term inflation expectations

• Inflation expectations in Italy and Spain seem to have benefited the most