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Unwarranted spread widening: measurement issues (part 2)

Eco week 22-26 // 27 June 2022  
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EDITORIAL  
UNWARRANTED SPREAD WIDENING: MEASUREMENT ISSUES (PART 2)  
A lasting, unwarranted widening of sovereign spreads in the euro area would represent an excessive tightening of  
financial conditions and weigh on activity and demand. It would run into conflict with the objectives of the ECB in  
the context of its monetary policy normalisation. Spreads are influenced by various fundamental variables that are  
directly or indirectly related to debt sustainability issues. These tend to be slow-moving. Sovereign spreads also  
depend on the level of risk aversion, a variable that fluctuates a lot and which is influenced by global factors. This  
complicates the assessment of whether an observed spread widening is warranted or not.  
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The recent, significant widening of sovereign spreads in the euro area ECB research for the period 1999-2010 shows that in the euro area  
has triggered a renewed interest in the drivers of the difference between the public sector balance and the debt ratio play a statistically  
government bond yields in a given country and the yield on German significant role in explaining the behaviour of sovereign spreads. The  
government bonds of equivalent maturity. This interest is influenced latter are positively correlated with financial risk, represented by the  
by comments from ECB governing council members about the need to VIX index. Slower growth, an appreciation of the real exchange rate  
address unwarranted spread widening.  
or a decline in bond market liquidity are associated with a widening  
of spreads. Credit ratings are significant but their influence is small.  
Importantly, during the European sovereign debt crisis, the sensitivity  
of bond prices to fundamentals increased. More recent research comes  
to similar conclusions on these variables and identifies the role of QE  
Putting a number on ‘unwarranted’ is a huge challenge considering  
that the sovereign spread depends on several variables. Moreover, the  
relationship – the beta in statistical terms – is time-varying. When Bund  
yields rise, the spread between Italian and German government bonds  
the BTP-Bund spread – often widens but sometimes the opposite  
happens. Recently, the relationship has been positive and increasingly  
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so . The prospect of higher policy rates has played an important role.  
GERMAN INTEREST RATE (1 YEAR IN 1 YEAR) AND BTP-BUND SPREAD  
As shown in chart 1, the rise of the one-year forward rate of German  
government paper with a maturity of one year – a measure of monetary  
policy expectations – to a very large degree corresponds with the  
increase in 10-year Bund yields and both series are highly correlated  
with the rise in the BTP-Bund spread.  
Bund 10 year  
BTP 10 year - Bund 10 year  
German 1 year in 1 year  
%
3.5  
3.0  
From a Finance theory perspective, one would indeed expect a positive  
beta between German rates and sovereign spreads. When the risk-  
free rate increases, a smaller exposure to riskier assets is needed to  
meet the target return. Macroeconomic theory also sees a positive  
relationship but for another reason: higher interest rates influence the  
debt sustainability parameters. Indeed, supposing that the debt ratio  
was initially stable, a permanent increase in the average borrowing  
cost would require, ceteris paribus, a reduction in the public sector  
primary deficit or a smaller primary surplus to keep the debt ratio  
2.5  
2.0  
1.5  
1.0  
0.5  
0.0  
-
-
0.5  
1.0  
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stable . Especially in case of a lasting, significant increase in interest  
-1.5  
2013 2014 2015 2016 2017 2018 2019 2020 2021 2022  
rates, there may be concern that measures taken to stabilize the debt  
ratio would be slow or insufficient. Such concern would be reflected in  
a higher spread.  
CHART 1  
SOURCE: REFINITIV, BLOOMBERG, BNP PARIBAS  
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See Unwarranted spread widening : measurement issues, Ecoweek, BNP Paribas, 20 June  
022.  
. The primary balance (i.e. the public sector budget balance excluding interest charges)  
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3. Source: António Afonso, Michael G. Arghyrou and Alexandros Kontonikas, The  
determinants of sovereign bond yield spreads in the EMU, ECB working paper 1781, April  
2015.  
4. The following countries were analysed : Austria, Belgium, Finland, France, Greece,  
Ireland, Italy, Netherlands, Portugal and Spain.  
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that stabilizes the debt/GDP ratio is equal to (r-g).(debt/GDP) with r = average cost of the  
debt and g = nominal GDP growth. When r > g, a primary surplus will be required to keep the  
debt ratio stable. The opposite holds when r < g.  
Spreads are influenced by slow-moving fundamental variables  
that are directly or indirectly related to debt sustainability  
issues but also by short-term fluctuations in risk aversion. This  
complicates the assessment of whether an observed spread  
widening is warranted or not.  
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Eco week 22-26 // 27 June 2022  
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measures in influencing spreads. Jordi Paniaguaa et al emphasize that  
market sentiment and hence spreads also depend on differences in  
output growth between core and peripheral countries. This argues for  
macroeonomic policy coordination to enhance convergence within the  
EURO AREA HIGH YIELD BOND SPREAD AND  
SOVEREIGN SPREAD ITALY-GERMANY  
BTP 10 year - Bund 10 year  
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%
Eurozone. Research by the IMF highlights the role of global risk aversion  
Euro HY option adjusted spread  
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3
2
1
0
in the behaviour of spreads. Between July 2007 and September 2008 – a  
period that the authors call the financial crisis build-up – Germany and  
other core countries benefitted from flight-to-quality flows whereas risk  
aversion was weighing adversely on peripheral countries.  
To illustrate the role of risk aversion, charts 2 and 3 compare the  
evolution of the BTP-Bund spread and, respectively, the euro high yield  
spread and the Euro Stoxx 50 equity index. Recently, the correlation  
between the sovereign spread and the high yield spread has been  
high and this also applies to the sovereign spread and equity market  
developments. This suggests that in recent months, risk aversion has  
increased, probably on the back of a prospect of higher ECB policy rates  
and a more uncertain growth outlook, in relation with elevated inflation  
and the war in Ukraine.  
2
013 2014 2015 2016 2017 2018 2019 2020 2021 2022  
CHART 2  
SOURCE: REFINITIV, FRED ST. LOUIS, BNP PARIBAS  
To conclude, spreads are influenced by various fundamental variables  
that are directly – public balance, debt – or indirectly economic growth-  
related to debt sustainability issues. These tend to be slow-moving.  
Sovereign spreads also depend on the level of risk aversion, a variable  
that fluctuates a lot and which is influenced by global factors. This  
complicates the assessment of whether an observed spread widening  
is warranted: it may be unwarranted based on the (expected) evolution  
of the fundamentals whilst making sense in an environment of rising  
risk aversion.  
EURO STOXX 50 AND SOVEREIGN SPREAD ITALY-GERMANY  
BTP 10 year - Bund 10 year  
Euro Stoxx 50 (inverted rhs)  
%
2
2
3
3
4
000  
500  
000  
500  
000  
3
3
2
2
1
1
0
0
.5  
.0  
.5  
.0  
.5  
.0  
.5  
.0  
William De Vijlder  
4500  
2
013 2014 2015 2016 2017 2018 2019 2020 2021 2022  
CHART 3  
SOURCE: REFINITIV, BNP PARIBAS  
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Source: António Afonso and João Jalles, Quantitative Easing and Sovereign Yield Spreads: Euro-Area Time-Varying Evidence, REM Working Paper 020-2017, December 2017.  
. Jordi Paniaguaa, Juan Sapenaa, Cecilio Tamaritba, Sovereign debt spreads in EMU: The time-varying role of fundamentals and market distrust, Journal of Financial Stability 33 (2017)  
87–206  
Source: Carlos Caceres, Vincenzo Guzzo and Miguel Segoviano, Sovereign Spreads: Global Risk Aversion, Contagion or Fundamentals?, IMF Working Paper, 10/120, May 2010.  
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