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Financial indicators signaling correlation changes in sovereign bond markets

Roberto A. De Santis and Michael Stein

Journal of Banking & Finance, 2015, vol. 56, issue C, 86-102

Abstract: We use a Smooth Transition Conditional Correlation GARCH (STCC-GARCH) model applied to the euro area monetary policy rates and sovereign yields of Italy, Spain and Germany at 5-year maturity to estimate the threshold level of the signals above which the sovereign bond market moves to a crisis regime. We show that the threshold to a crisis regime for Italy and Spain is reached when (i) their 5-year sovereign yield spreads amount to about 90 basis points; (ii) their 5-year CDS spreads amount to about 155 basis points or (iii) the 5-year spread between the Kreditanstalt für Wiederaufbau (KfW) bond and the German Bund amounts to about 30–40 basis points. Using impulse responses, we find that the STCC-GARCH with the KfW-Bund spread has leading properties, a feature corroborated by the fact that this indicator suggested a shift to a crisis regime already in August 2007 and has been signaling an improvement of the situation already in the autumn of 2012. An out-of-sample forecast of the STCC-GARCH model is also provided, which is both a novelty and a further robustness check for the stability of the model.

Keywords: Correlation breakdowns; Monetary policy; Regime changes; Government bonds; Multivariate GARCH (search for similar items in EconPapers)
JEL-codes: G12 G15 F36 (search for similar items in EconPapers)
Date: 2015
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Handle: RePEc:eee:jbfina:v:56:y:2015:i:c:p:86-102