Sovereign Bond Yield Spreads in the Eurozone

Financial fragmentation in the Eurozone is still reflected in the widening of sovereign bond spreads during uncertain times, streaming from domestic and external funding imbalances or monetary policy stances. The Euro area has encountered severe financial difficulties. After the Great Financial Depression, European economies, particularly Greece, Ireland, Italy, Portugal, and Spain (so-called GIIPS countries), faced the dynamics of budget deficits and experienced significant increases in their sovereign bond yields, which decreased the confidence of investors in the ability of these countries to meet their debt commitments. Therefore, the divergence in long-term bond yields in European countries started in 2010 and has grown substantially since 2012 (Cuaresma & Fernández, 2024). The concerns about the euro area breakup increased in the half of 2012, where Italian and Spanish 5-year sovereign yield spreads reached record highs because of self-fulfilling speculation and multiple equilibria. Despite carrying out some significant reforms in the European Union after the sovereign crisis in 2010, such as introducing unconventional monetary policies, government bond purchase programs, European Stability Mechanism (ESM) or other multiple safety lines in Europe, the Euro area was still fragmented in nature, and it revealed after the new economic crisis (Covid-19 and the Russia invasion to Ukraine). Financial fragmentation can be studied in the framework of sovereign bond yield spreads, as the Euro area governments published the bonds in a currency with no complete control and no guarantee to have the necessary budget to pay the investors out at maturity, which leads to reducing the confidence of investors, forcing the government to default and increasing the risk premium. Therefore, Sovereign bond yield spreads are the index used to quantify the fragility of the countries’ financial structure and the risk of market failure. This study explores the gap between sovereign bond spreads and sovereign credit default swap spreads and proves the presence of a high cointegration between sovereign CDS and sovereign bond markets. Moreover, it evidenced the association between sovereign bond spreads and other country-specific macroeconomic fundamentals, including debt to GDP ratio (as a proxy for fiscal condition) and inflation. Additionally, we employ the euro–dollar base swap rate as a proxy for the scarcity of dollar funding in the Eurozone and the EURO Stock VIX index to capture the effect of investors’ risk aversion and investor uncertainty on the sovereign yield spreads in the Eurozone. Moreover, to measure sovereign spread, we used 7 the difference between each member state's 10-year sovereign bond yields from the average Eurozone 10-year sovereign bond yields. Also, increasing fundamental doubts over the integrity of the Eurozone highlights the critical role of monetary policies and fiscal discipline in stabilizing the euro area’s sovereign bond markets. Therefore, this paper aims to study the effectiveness of conventional and unconventional monetary policy by the European Central Bank (ECB). The rescue packages provided by the European Commission through the most significant European RFA (that is, European Stability Mechanism-ESM) disbursements, studying the effects of the Excessive Deficit Procedure (EDP) as an EU-level fiscal austerity and the effectiveness of the recent EU’s recovery plan- Recovery and Resilience Facility (RRF) which is the milestone program under the Next Generation EU (NGEU) to decrease the volatility in EU sovereign bond markets. Therefore, the thesis aims to identify the determinant factors of the Eurozone’s sovereign spread using a panel vector error correction model (VECM) for the non-pandemic period (2008Q1–2019Q4), which covers the events of the Global Financial Crisis and the Eurozone sovereign debt crisis that led to some significant reforms in the euro area. We then extended the period to 2022Q3 to add two more recent crises, the COVID-19 pandemic in 2020 and the energy price shock in 2022, to evaluate the efficiency of the abovementioned reforms.