Liquidity and Tail-Risk Interdependencies in the Euro Area Sovereign Bond Market

57 Pages Posted: 4 Nov 2019

See all articles by Daragh Clancy

Daragh Clancy

European Stability Mechanism

Peter G. Dunne

Central Bank of Ireland

Pasquale Filiani

Central Bank of Ireland

Multiple version iconThere are 2 versions of this paper

Date Written: October 24, 2019

Abstract

The likelihood of severe contractions in an asset's liquidity can feed back to the ex ante risks faced by the individual providers of such liquidity. These self-reinforcing effects can spread to other assets through informational externalities and hedging relations. We explore whether such interdependencies play a role in amplifying tensions in European sovereign bond markets and are a source of cross-market spillovers. Using high-frequency data from the inter-dealer market, we find significant own- and cross-market effects that amplify liquidity contractions in the Italian and Spanish bond markets during times of heightened risk. The German Bund's safe-haven status exacerbates these amplification effects. We provide evidence of a post-crisis dampening of cross-market effects following crisis-era changes to euro area policies and institutional architecture. We identify a structural break in Italy's cross-market conditional correlation during rising political tensions in 2018, which significantly reduced liquidity. Overall, our findings demonstrate potential for the provision of liquidity across sovereign markets to be vulnerable to sudden fractures, with possible implications for euro area economic and financial stability.

Keywords: Liquidity, Tail risks, Feedback loops, Spillovers

JEL Classification: G01, G15, F36

Suggested Citation

Clancy, Daragh and Dunne, Peter G. and Filiani, Pasquale, Liquidity and Tail-Risk Interdependencies in the Euro Area Sovereign Bond Market (October 24, 2019). Available at SSRN: https://ssrn.com/abstract=3474826

Daragh Clancy

European Stability Mechanism ( email )

6a Circuit de la Foire Internationale
L-1347
Luxembourg

Peter G. Dunne (Contact Author)

Central Bank of Ireland ( email )

P.O. Box 559
Dame Street
Dublin, 2
Ireland

Pasquale Filiani

Central Bank of Ireland ( email )

P.O. Box 559
Dame Street
Dublin, 2
Ireland

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