Extreme Weather Events, Fiscal Space, and the Term Structure of Sovereign Debt

We study the impact of extreme weather events on global sovereign bond yields. Using state-dependent panel local projections, we show that the sovereign's fiscal position determines the sign of the yield response to natural disaster shocks. Yields decline significantly in fiscally constrained economies and rise in unconstrained ones, a pattern that remains masked in unconditional specifications. The reason is that government expenditure increases in unconstrained economies and remains flat in constrained ones, generating divergent inflationary dynamics that transmit to the yield curve. The state-dependent transmission operates through different channels. In advanced economies, the yield response is driven by the expected path of policy rates, while the term premium plays a larger role in emerging markets. Our findings highlight fiscal space as a key determinant of how climate shocks propagate through sovereign debt markets.