The Term Structure of Interest Rates in a Heterogeneous Monetary Union

60 Pages Posted: 11 Jul 2022

See all articles by James S. Costain

James S. Costain

Banco de España - Research Department

Galo Nuño

Banco de España; Bank for International Settlements (BIS)

Carlos Thomas

Banco de España

Date Written: July 7, 2022

Abstract

The highly asymmetric reaction of euro area yield curves to the announcement of the ECB’s pandemic emergency purchase programme (PEPP) is hard to reconcile with the standard 'duration risk extraction' view of the transmission of central banks’ asset purchase policies. This observation motivates us to build a no-arbitrage model of the term structure of sovereign interest rates in a two-country monetary union, in which one country issues default-free bonds and the other issues defaultable bonds. We derive an affine term structure solution, and we decompose yields into term premium and credit risk components. In an extension, we endogenise the peripheral default probability, showing that the possibility of rollover crises makes it an increasing function of bond supply net of central bank holdings. We calibrate the model to Germany and Italy, showing that it matches well the reaction of these countries’ yield curves to the PEPP announcement. A channel we call “default risk extraction” accounts for most of the impact on Italian yields. The programme’s flexible design substantially enhanced this impact.

Keywords: sovereign default, quantitative easing, yield curve, affine model, COVID-19 crisis, ECB, pandemic emergency purchase programme

JEL Classification: E5, G12, F45

Suggested Citation

Costain, James S. and Nuño, Galo and Thomas, Carlos, The Term Structure of Interest Rates in a Heterogeneous Monetary Union (July 7, 2022). Banco de Espana Working Paper No. 2223, Available at SSRN: https://ssrn.com/abstract=4156014 or http://dx.doi.org/10.2139/ssrn.4156014

James S. Costain (Contact Author)

Banco de España - Research Department ( email )

Alcala 50
28014 Madrid
Spain

Galo Nuño

Banco de España ( email )

Alcala 50
Madrid 28014
Spain

Bank for International Settlements (BIS)

Centralbahnplatz 2
Basel, Basel-Stadt 4002
Switzerland

Carlos Thomas

Banco de España ( email )

Alcala 50
Madrid 28014
Spain

HOME PAGE: http://www.bde.es

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