Sovereign Debt Spreads within the Euro Area: When Fears Become Excess Fears

The issue of divergence of sovereign spreads in the Euro area, following the deep financial crisis initiated in 2008 can only in part be related to the stability of the institutional agreements behind the common currency. There is a widespread debate as of how spreads signal a justifiable credit risk differential within the area, or, rather, reflect irrational fears and subjective and biased reasoning. In this paper we suggest a way to filter out of the observed spreads a component which we dub physiological , which is the reflection of the reaction to difference between expectations and realizations of economic fundamentals. Such a component is a function of market volatility, a proxy which represents well how new information is processed. The model parameters are estimated over a tranquil period (2000-2007) and then, in keeping with a substantial stream of literature on the topic, they are kept unchanged over the more recent and more turbulent period (2008-2015). We apply our procedure on nine Euro area countries and the US. The difference between observed and predicted values is what we label excess fears . As a result, the actual spread is much higher than it should be using as a reference a physiological view where news on macroeconomic fundamentals do indeed induce a reaction by the markets, but that this reaction was excessive when compared to what similar episodes had generated in the past.