Abstract:This paper provides a study of bond yield differentials among EU government bonds issued between 1993 and 2005 on the basis of a unique dataset of issue spreads in the US and DM (Euro) bond market. Interest differentials between bonds issued by EU countries and Germany or the USA contain risk premiums which increase with fiscal imbalances and depend negatively on the issuer's relative bond market size. The start of the European Monetary Union has shifted market attention to debt service payments as the key measure of indebtedness and eliminated liquidity premiums in the euro area.

We study the determinants of sovereign bond yield spreads across 10 EMU countries between Q1/1999 and Q1/2010. We apply a semiparametric time-varying coefficient model to identify, to what extent an observed change in the yield spread is due to a shift in macroeconomic fundamentals or due to altering risk pricing. We find that at the beginning of EMU, the government debt level and the general investors' risk aversion had a significant impact on interest differentials. In the subsequent years, however, financial markets paid less attention to the fiscal position of a country and the safe haven status of Germany diminished in importance. By the end of 2006, two years before the fall of Lehman Brothers, financial markets began to grant Germany safe haven status again. One year later, when financial turmoil began, the market reaction to fiscal loosening increased considerably. The altering in risk pricing over time period confirms the need of time-varying coefficient models in this context. JEL Classification Codes: C14, E43, E62, G12, H62, H63

Abstract:We investigate the effects of official fiscal data and creative accounting signals on interest rate spreads between bond yields in the European Union. Our model predicts that risk premia contained in government bond spreads should increase in both, the official fiscal position and the expected "creative" part of fiscal policy. The relative importance of these two signals depends on the transparency of the country. Greater transparency reduces risk premia. The empirical results confirm the hypotheses. Creative accounting increases the spread. The increase of the risk premium is stronger if financial markets are unsure about the true extent of creative accounting. Fiscal transparency reduces risk premia. Instrumental variable regressions confirm these results by addressing potential reverse causality problems and measurement bias. Keywords:Risk premia, government bond yields, creative accounting, stock-flow adjustments, gimmickry, transparency JEL-Classification:G12, E43, E62, H6, F34 The reaction of financial markets to this creative accounting is an important policy topic. If financial markets do not price in the de facto deterioration of the fiscal position due to creative accounting, while punishing official deficit data, risk premia could be lowered by shifting deficits to creative accounting. Non-technical summaryThe lower interest rate would provide an incentive to governments to beautify their fiscal data. To our knowledge, no study so far analyzes whether financial markets take note of fiscal window-dressing when pricing government bonds. This is the purpose of our study. In particular, we study whether spreads react, besides official fiscal data, to stock-flow adjustments or to an alternative measure of creative accounting by Koen and van den Noord (2005).Furthermore, we investigate, in how far fiscal transparency affects risk spreads. Kopits and Craig (1998) argue that international financial markets are likely to demand lower premiums from governments that are forthcoming about their fiscal position and risk. The argument is that markets can be more certain about a fiscally transparent government's ability and willingness to service its obligation. A more transparent budget process in addition helps financial markets to detect creative accounting more easily and to assess the true fiscal position of a country. This might increase the spread since more creative accounting becomes known to the markets.We develop a portfolio model of interest differentials based on Bernoth, von Hagen, and Schuknecht (2004). In this model, interest rate differentials increase with a relative worsening of the fiscal position due to an increase in the government's default probability. The model is augmented to account for fiscal creative accounting and fiscal transparency. Creative accounting appearing in the media constitutes a news signal. The more reliable this signal, the greater will be the effect of creative accounting on the expected fiscal position of a country. Creative accounting news should therefore incr...

For an effective and smooth monetary policy, it is important that interest rate expectations are in line with central bank policy intentions. The predictability of money market interest rates is, therefore, an indicator of transparency and clarity in the communication of monetary policy and of the effectiveness of monetary policy implementation.In this paper, we analyse three aspects of the predictability of money market rates in the European Monetary Union (EMU). The first is the efficiency of the three-month Euribor interest rate futures markets. The second aspect is the effect of ECB policy announcements on the volatility of Euribor futures rates, and the third aspect is the effect of ECB policy announcements on the prediction error contained in Euribor futures rates. We find that the new Euro money markets were able to predict short-term rates well. Our results suggest that the ECB communication of monetary policy has worked well during the first years of EMU and that the predictability of ECB policy decisions seems to have improved over

We study the determinants of sovereign bond yield spreads across 10 EMU countries between Q1/1999 and Q1/2010. We apply a semiparametric time-varying coefficient model to identify, to what extent an observed change in the yield spread is due to a shift in macroeconomic fundamentals or due to altering risk pricing. We find that at the beginning of EMU, the government debt level and the general investors' risk aversion had a significant impact on interest differentials. In the subsequent years, however, financial markets paid less attention to the fiscal position of a country and the safe haven status of Germany diminished in importance. By the end of 2006, two years before the fall of Lehman Brothers, financial markets began to grant Germany safe haven status again. One year later, when financial turmoil began, the market reaction to fiscal loosening increased considerably. The altering in risk pricing over time period confirms the need of time-varying coefficient models in this context. JEL Classification Codes: C14, E43, E62, G12, H62, H63