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The Term Structure of Interest Rates in a Heterogeneous Monetary Union

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Listed:
  • James Costain

    (Banco de España)

  • Galo Nuño

    (Banco de España)

  • Carlos Thomas

    (Banco de España)

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.

Suggested Citation

  • James Costain & Galo Nuño & Carlos Thomas, 2022. "The Term Structure of Interest Rates in a Heterogeneous Monetary Union," Working Papers 2223, Banco de España.
  • Handle: RePEc:bde:wpaper:2223
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    References listed on IDEAS

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    Cited by:

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    2. Jouvanceau, Valentin & Mikaliunaite-Jouvanceau, Ieva, 2023. "ECB monetary communications: Market fragmentation at stake," Economics Letters, Elsevier, vol. 225(C).
    3. Jappelli, Ruggero & Pelizzon, Loriana & Subrahmanyam, Marti G., 2023. "Quantitative easing, the repo market, and the term structure of interest rates," SAFE Working Paper Series 395, Leibniz Institute for Financial Research SAFE.
    4. Nissinen, Juuso & Sihvonen, Markus, 2022. "Bond convenience curves and funding costs," Bank of Finland Research Discussion Papers 11/2022, Bank of Finland.
    5. Motto, Roberto & Özen, Kadir, 2022. "Market-stabilization QE," Working Paper Series 2640, European Central Bank.
    6. Christophe Blot & Caroline Bozou & Jérôme Creel & Paul Hubert, 2022. "The Conditional Path of Central Bank Asset Purchases," Working papers 885, Banque de France.
    7. Malliaropulos, Dimitris & Migiakis, Petros, 2023. "A global monetary policy factor in sovereign bond yields," Journal of Empirical Finance, Elsevier, vol. 70(C), pages 445-465.

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    More about this item

    Keywords

    sovereign default; quantitative easing; yield curve; affine model; COVID-19 crisis; ECB; pandemic emergency purchase programme;
    All these keywords.

    JEL classification:

    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • F45 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Macroeconomic Issues of Monetary Unions

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