EcoWeek

Unwarranted spread widening: measurement issues

Eco week 22-25/ 20 June 2022  
economic-research.bnpparibas.com  
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EDITORIAL  
UNWARRANTED SPREAD WIDENING: MEASUREMENT ISSUES  
In recent weeks, the prospect of several ECB rate hikes has caused an increase in Bund yields and, unexpectedly, several  
sovereign spreads. Beyond a certain point, higher spreads may become unwarranted. Under such circumstances,  
the ECB might consider stepping in to avoid that its policy transmission would be impacted. Determining whether  
sovereign spreads have increased too much is a real challenge. Historically, based on a 20-week moving window, the  
relationship (beta) between the BTP-Bund spread and Bund yields fluctuates a lot, so this calls for taking a longer  
perspective. Using data since 2013, the current spread is in line with an estimate based on current Bund yields.  
Clearly, other economic variables should be added to the analysis. It shows the complexity of the task should the  
ECB commit to address unwarranted spread widening.  
Recently, certain euro area sovereign spreads - the difference between In such case, the ECB considers, with reason, it should step in to avoid  
government bond yields in a given country and the yield on German that its policy transmission would be impacted. This is the logic behind  
government bonds of equivalent maturity, which are considered as the ‘believe me it will be enough’ speech of Mario Draghi in July 2012  
the risk-free benchmark, - have widened significantly. This has raised or behind Isabel Schnabel’s recent speech at the Sorbonne in which  
concern that it could influence the transmission of monetary policy and she explained “there can be no doubt that, if and when needed, we can  
has even led to an ad hoc meeting of the ECB governing council on 15 and will design and deploy new instruments to secure monetary policy  
1
3
June “to exchange views on the current market situation” .  
transmission and hence our primary mandate of price stability.”  
When the ECB signals its intentions to raise its deposit rate, one should  
expect that the entire structure of short and long-term interest rates,  
both in capital markets (government and corporate bond yields) and  
in bank-based financing, will shift upwards. Higher yields on German  
government bonds should cause some spread widening for more  
heavily indebted sovereign issuers but also for corporates (chart 1).  
This can occur even in the absence of a worsening in the near-term  
economic outlook. Investors who target a certain yield need to take  
less exposure to e.g. Italy or corporate bonds when Bund yields have  
increased significantly. The spread can also increase because investors  
require some extra yield as a protection against a possible deterioration  
of the credit quality.  
EURO AREA HIGH YIELD BOND SPREAD AND SOVEREIGN SPREAD  
Bund yield (10 year)  
%
BTP - Bund spread (10 year)  
6
Euro High Yield option adjusted spread, %  
5
4
3
2
1
However, beyond a certain point, higher spreads become unwarranted  
based on the fundamentals in terms of credit quality. As a consequence,  
demand and economic activity might suffer in certain countries  
because, due to a disproportionate increase in long term interest rates -  
reflecting higher Bund yields and a wider spread -, financial conditions  
would tighten more than what the ECB was expecting when deciding  
to raise the deposit rate. This gives rise to fragmentation risk. The  
disconnect between spreads and fundamentals worsens the economic  
outlook, thereby causing higher risk aversion and further spread  
widening, ‘giving rise to non-linear and destabilizing dynamics’.2  
0
2022  
-
1
January  
February  
March  
April  
May  
June  
CHART 1  
SOURCE: REFINITIV, FRED ST. LOUIS, BNP PARIBAS  
1
.
Source: ECB, Statement after the ad hoc meeting of the ECB Governing Council, 15 June  
022.  
ECB executive board member Isabel Schnabel defines fragmentation in terms of yields  
2
2.  
policy in a currency union, Commencement speech by Isabel Schnabel, Member of the  
Executive Board of the ECB, to the graduates of the Master Program in Money, Banking,  
Finance and Insurance of the Panthéon-Sorbonne University, Paris, 14 June 2022  
3. Source: see footnote 2.  
instead of spreads: “fragmentation reflects a sudden break in the relationship between  
sovereign yields and fundamentals, giving rise to non-linear and destabilizing dynamics.”  
Source: United in diversity – Challenges for monetary  
Historically, based on a 20-week moving window, the relationship  
beta) between the BTP-Bund spread and Bund yields fluctuates a lot,  
(
so this calls for taking a longer perspective. Using data since 2013,  
the current spread is in line with an estimate based on current Bund  
yields.  
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Eco week 22-25/ 20 June 2022  
economic-research.bnpparibas.com  
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Announcing a commitment is one thing, implementing it is another and  
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raises a host of complex questions starting with what is an unwar-  
BTP-BUND SPREAD AND BUND YIELD (10-YEAR)  
ranted widening of spreads?  
An obvious starting point is to look at the relationship between sover-  
Beta (20 week)  
Bund yield (20-week mav)  
Beta (entire sample)  
eign spreads and Bund yields. Chart 2 does this for the Italian spread  
%
Spread (20-week mav)  
5
(
2
BTP-Bund) using weekly data since 2013 by calculating the rolling  
3.0  
0-week beta between the BTP-Bund spread and the 10-year Bund  
2.5  
2.0  
1.5  
yield. This coefficient fluctuates a lot and changes sign. As an example,  
in the spring of 2018 it was very negative due to a significant spread  
widening - on the back of political uncertainty in Italy - and a decline  
in German yields.  
1.0  
0.5  
0.0  
0.5  
1.0  
The variability of the beta raises the question of which period to use  
when assessing whether the observed spread is warranted given the  
level of Bund yields. The table shows in row 1 that, using the most  
recent 20 weeks of data, the observed spread on 17 June was 20 basis  
points below the estimated spread. Row 2 uses 20 weeks of data start-  
ing in August 2021. The beta is significantly lower and the observed  
spread on 17 June was 65 basis points above the estimated one. Using  
the entire sample (row 3), with data going back to 2013, the observed  
spread on 17 June was 17 basis points below the estimate.  
-
-
-1.5  
2013  
2014  
2015  
2016  
2017  
2018  
2019  
2020  
2021  
2022  
CHART 2  
SOURCE: REFINITIV, BNP PARIBAS  
Different conclusions can be drawn from these calculations. One,  
based on a 20-week moving window, the relationship (beta) between  
the BTP-Bund spread and Bund yields fluctuates over time. After being  
in negative territory since early 2021, the beta has recently seen a  
significant increase and is now positive again. Two, considering that  
Bund yields have moved higher, this has created a feeling of a ‘double  
whammy’ for the spread on the back of a rise in German yields and an  
increased beta. Three, the variability of the short-term beta calls for  
taking a longer perspective. Using data since 2013, the current spread  
is more or less in line with an estimate based on current Bund yields.  
Four, clearly there is a need to incorporate additional economic vari-  
ables in the analysis because they will condition the reaction of Italian  
yields to changes in German yields. One can think of the stance of  
monetary policy - the role of net asset purchases, the outlook for the  
deposit rate -, the outlook for growth and public finances, the risk ap-  
petite of investors, etc. It shows the complexity of the task when com-  
mitting to address unwarranted spread widening, all the more so given  
the number of spreads that need to be monitored.  
William De Vijlder  
4
.
E.g. conditionality, target spread, interference with monetary policy, etc.  
5
.
2013 was chosen to avoid that the euro sovereign debt crisis would influence the  
estimation results.  
ESTIMATED SPREAD ITALY-GERMANY  
Observed minus  
estimated  
Estimation period (weekly data)  
Observed spread Estimated spread  
Intercept  
Beta  
Bund yield*  
BTP yield*  
2
1 January 2022 - 10 June 2022  
-0.20  
0.65  
2.045  
2.045  
2.045  
2.244  
1.395  
2.211  
1.411  
1.192  
1.583  
0.486  
0.119  
0.366  
1.716  
1.716  
1.716  
3.761  
3.761  
2
7 August 2021 - 14 January 2022  
4
January 2013 - 10 June 2022  
-0.17  
3.761  
*
yield on 17 June 2022  
TABLE 1  
SOURCE: REFINITIV, BNP PARIBAS  
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