Beyond Fragmentation: Unraveling the Drivers of Yield Divergence in the euro area

This paper provides a novel and high-frequency index of sovereign fragmentation in the euro area. The proposed methodology offers a decomposition of sovereign yields into the common trend, market conditions, and fundamentals-based divergence, which are uncorrelated to fragmentation. Therefore, the fragmentation index constitutes a bottom-line indicator for euro area Central Banks, as measuring disorderly market dynamics in sovereign markets not warranted by fundamentals. In that sense, this paper provides relevant conclusions about the effectiveness of monetary policy interventions, pointing to a significant effect of market stabilization announcements, such as TPI, in reducing sovereign fragmentation. I contribute to the literature as estimating the uncorrelated drivers of euro area yields divergence using a Restricted Principal Components Analysis. The estimated factors are later used to assess the effect of fragmentation, market and fundamentals on country's yields through several economic regimes, pointing to differences across countries and time.