Convergence and Anchoring of Yield
Curves in the Euro Area
Michael Ehrmann
Marcel Fratzscher
European Central Bank
European Central Bank
Refet Gürkaynak
Eric T. Swanson
Bilkent University
Federal Reserve Bank of San Francisco
Conference on International Financial Integration
Federal Reserve Bank of Atlanta
November 30, 2007
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.
European Monetary Union: Background
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
Overview of the Paper
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)
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
Table 4: Principal Components Analysis of 2-year Yields across Countries
sample
contribution of:
pre-EMU
post-EMU
first PC
.895
.998
second PC
.097
.001
Convergence of Yields: Sensitivity
Convergence of Yields: Sensitivity
Convergence of Yields: Sensitivity
Figure 3: Response of 2-year Yield to Macroeconomic Surprises
ISM - NAPM
US inflation
3
2
1
0
0
-1
.5
-2 -1
1
0
1.5
1
2
2
2.5
Non-farm payroll employment
1994 1996 1998 2000 2002 2004 2006
1994199619982000200220042006
1994199619982000200220042006
.
.
.
France inflation
Germany inflation
4
2
1
0
0
-1.5
1
-1 -.5
2
3
0
3
.5
IFO confidence
1994199619982000200220042006
.
.
Italy inflation
Spain inflation
Euro area M3
1994199619982000200220042006
.
.5
0
-.5
-2 -1
0
0
.5
1
1
1
2
1.5
1994199619982000200220042006
.
1.5
1994199619982000200220042006
1994199619982000200220042006
.
1994199619982000200220042006
.
Convergence of Yields: Sensitivity
Figure 4: Heterogeneity in the Effects of Macroeconomic Surprises
1
.5
0
.5
1
1.5
.2 .4 .6 .8
1.5
2
US inflation
1
ISM - NAPM
2
Non-farm payroll employment
1994 1996 1998 2000 2002 2004 2006
1994199619982000200220042006
1994199619982000200220042006
.
.
.
France inflation
Germany inflation
2
1.5
0
0
.5
.5
1
1
1.5
.2 .4 .6 .8
2
1
2.5
IFO confidence
1994199619982000200220042006
1994199619982000200220042006
.
.
.
Italy inflation
Spain inflation
Euro area M3
1994199619982000200220042006
.
1
.2 .4 .6 .8
0
0
0
.5
1
.2 .4 .6 .8
1.5
1994199619982000200220042006
1994199619982000200220042006
.
1994199619982000200220042006
.
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
Figure 5: Response of 9-year-ahead 1-year Forward Rate to Macroeconomic Surprises
2
0
0
-2
-4
0
-2
-5
-10
US inflation
4
ISM - NAPM
2
5
Non-farm payroll employment
1994199619982000200220042006
1994199619982000200220042006
.
.
.
France inflation
Germany inflation
0 2 4 6 8
-1
-1
0 1 2 3
0 1 2 3 4
IFO confidence
10
1994 1996 1998 2000 2002 2004 2006
1994199619982000200220042006
.
.
Italy inflation
Spain inflation
Euro area M3
1994199619982000200220042006
.
1
0
-2 -1
-1
0
-3 -2 -1
1
0 1 2
2
1994199619982000200220042006
.
2 3
1994199619982000200220042006
1994199619982000200220042006
.
1994199619982000200220042006
.
Far-Ahead Forward Rates
Figure 6: Heterogeneity in the Effects of Macroeconomic Surprises on the 9-year-ahead 1-year Forward Rate
2
2
.
.5
.5
1
1
2
1
.
1.5
1.5
4
3
.
US inflation
2.5
ISM - NAPM
5
Non-farm payroll employment
1994199619982000200220042006
1994199619982000200220042006
.
.
.
France inflation
Germany inflation
0
0
.5
.
1.
1.5
2
2
IFO confidence
0 1 2. 3 4 5
1994 1996 1998 2000 2002 2004 2006
1994199619982000200220042006
.
.
Italy inflation
Spain inflation
Euro area M3
1994199619982000200220042006
.
.
.5
0
0
.6 .8
.5
1.
.
1
1
1.5
2
1.5
1994199619982000200220042006
.
1.21.41.6
1994199619982000200220042006
1994199619982000200220042006
.
1994199619982000200220042006
.
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