Impact of QE on European Sovereign Bond Market Equilibrium

This chapter evaluates the impact of the European Central Bank's (ECB's) quantitative easing (QE) programmes on bond market equilibrium. Therefore, we develop an original theoretical model to understand the formation of longterm sovereign rates in the euro zone. More specifically, it is a two-country international bond portfolio choice model that generalizes the traditional results of the term structure interest rates theory. In particular, in addition to traditional properties, long-term equilibrium rates depend on future bond yields' anticipated variances and covariances, which are considered as a component of a volatility risk premium. Using CDS as a variable to control for default risks, we test the model empirically for the period January 2006 to September 2016. We conclude that the ECB's QE programme, which began in March 2015, has accelerated the ‘defragmentation process' of the European bond markets that began with the Outright Monetary Transactions programme. However, the results of a Forbes and Rigobon test do not show that the QE programme has led to a significant increase in the conditional correlations between bond markets. In a supplementary empirical test, we show that QE has significantly reduced the sensitivities of bond yield spreads to the premiums paid on sovereign CDS.