Monetary Policy and Long Term Rates in the Euro Area

Monetary Policy and Long Term Rates in the Euro Area Carlo A Favero IGIER and Dept.of Finance, Bocconi University

Milan, May 2013

Carlo A Favero IGIER and Dept.of Finance, Bocconi University GIC CB()Series, Milan

Milan, May 2013

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Outline The problem of the transmission of monetary policy in Europe:one monetary policy, many long term yields The factors explaining spreads in the euro area the importance of the default risk factos and the exchange risk factor ‥ight to safety towards German Bunds

Why "believe me it will be enough" worked The risk scenario: from a con‌dence crisis (due to spreads between yields) to a sustainability crisis (due to the level of yields) German and US Bonds are close substitute QE is determining very low level of safe yields (with possibly a negative risk premium). What happens to yields in the euro area when the Fed will implement the exit strategy ?

bottom line: Europe needs growth badly and fast, but that cannot come from monetary policy Carlo A Favero IGIER and Dept.of Finance, Bocconi University GIC CB()Series, Milan

Milan, May 2013

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One Monetary Policy Many Long-Term Yields

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Carlo A Favero IGIER and Dept.of Finance, Bocconi University GIC CB()Series, Milan

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Milan, May 2013

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Spreads in the euro area

Government bond spreads in the Euro area re‡ect three di¤erent components.

The …rst one is credit risk: sovereign issuers that are perceived as having a greater solvency risk, must pay investors a default risk premium.

The second one is expectations of exchange rate ‡uctuations.

The last component is liquidity risk, that is, the risk of having to sell (or buy) a bond in a thin market and, thus, at an unfair price and with higher transaction costs.

a prominent feature of the euro area bond crisis is the resurgence of expectations of exchange rate ‡uctuations

Carlo A Favero IGIER and Dept.of Finance, Bocconi University GIC CB()Series, Milan

Milan, May 2013

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Spreads in the euro area The standard approach to model spreads in the euro area is based on their projection on a combination of local …scal fundamentals and some proxy for global risk aversion.

Such an approach provided a congruent statistical model of the data up to 2009, in the absence of expectations of exchange rate ‡uctuations and in the presence of a comovement between the dominant credit risk factor and the secondary liquidity risk factor.

However, the onset of the euro debt crisis and the emergence of a probability of exit of some countries caused a generalized predictive failure.

A large part of this predictive failure is explained when ‡uctuations in the expectations of exchange rate devaluations are modelled via the dependence of each country’s spread on all the other countries’spreads and …scal fundamentals

Carlo A Favero IGIER and Dept.of Finance, Bocconi University GIC CB()Series, Milan

Milan, May 2013

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The BTP-BUND spread .

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Yield Spread BTP-BUND (left scale) projected Deficit/GDP (left scale) projected DEBT/GDP (right scale) US BAA-AAA spread

Carlo A Favero IGIER and Dept.of Finance, Bocconi University GIC CB()Series, Milan

Milan, May 2013

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Default and non-default component of yields spreads .

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Carlo A Favero IGIER and Dept.of Finance, Bocconi University GIC CB()Series, Milan

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Milan, May 2013

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Flight to quality: German Bunds

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10Y Fixed Interest Rates on Swaps Sovereign Bond (10Y) -CDS Difference

Carlo A Favero IGIER and Dept.of Finance, Bocconi University GIC CB()Series, Milan

Milan, May 2013

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Why "believe me it will be enough" worked

the euro area crisis has been so far a con…dence crisis in the euro weaker countries in terms of their …scal fundamentals where more strongly a¤ected the adjustment process paired with a clear statement (and LTRO plus OMT) that the ECB will do whatever it takes to save the euro generate a convergence process of spreads

Carlo A Favero IGIER and Dept.of Finance, Bocconi University GIC CB()Series, Milan

Milan, May 2013

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The Risk Scenario

Yields on German and US bonds are strongly correlated (safe havens); what will happen to Europe when an exit strategy from QE is implemented by the Fed ?

Carlo A Favero IGIER and Dept.of Finance, Bocconi University GIC CB()Series, Milan

Milan, May 2013

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Safe Havens

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Carlo A Favero IGIER and Dept.of Finance, Bocconi University GIC CB()Series, Milan

Milan, May 2013

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QE and the "bond bubble"

Long term rates are determined by two (unobervable factors): expected monetary policy and the term premium There is a nonnegligible probability that QE has generated a negative risk premium on US long term bonds what will happen to Europe when an exit strategy from QE is implemented by the Fed ?

Carlo A Favero IGIER and Dept.of Finance, Bocconi University GIC CB()Series, Milan

Milan, May 2013

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QE and the "bond bubble"

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Federal Funds Rate US 10-Year YTM

Carlo A Favero IGIER and Dept.of Finance, Bocconi University GIC CB()Series, Milan

Milan, May 2013

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QE and the market pricing of risk NBER contractions shaded 250

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Bloom et al. Index of Policy Uncertainty Implied volatility in S&P futures

Bloom et al. (http://www.policyuncertainty.com/media/BakerBloomDavis.pdf) construct an index from three types of underlying components: newspaper coverage of policy-related economic uncertainty, the number of federal tax code provisions set to expire in future years, disagreement among economic forecasters .

Carlo A Favero IGIER and Dept.of Finance, Bocconi University GIC CB()Series, Milan

Milan, May 2013

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The risk scenario

Exit from QE generates an increase in the level of long-term yields Europe might then move from a con‌dence crisis (due to spreads between yields) to a sustainability crisis (due to the level of yields) bottom line: Europe needs growth badly and fast (time is ticking for QE), but that cannot come from monetary policy

Carlo A Favero IGIER and Dept.of Finance, Bocconi University GIC CB()Series, Milan

Milan, May 2013

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