Eurozone Sovereign Yield Spreads and Diverging Economic Fundamentals

Abstract

We analyze the role of macroeconomic fundamentals for the term structure of sovereign bond yields. We take a structured economic news flow approach to obtain a continuously updated measure of fundamentals and focus on a sample with large variation in economic conditions, specifically the Eurozone area between 1999 and 2012. We find a strikingly important role for macro fundamentals along a number of dimensions. First, differences in economic growth explain 81\% of the yield spreads between AAA and non-AAA rated bonds. Second, levels and differences in economic growth are highly correlated with yield-based principal components, suggesting economic interpretations for latent factors. Third, levels and differences in economic growth roughly triple the predictive ability of five yield-based factors for bond returns, capturing a large portion of time-varying risk premia. Finally, this predictability cannot be replicated with the standard headline GDP growth.

Keywords: sovereign yield spread, real-time economic growth

JEL Classification: G12