Government bond market linkages: evidence from Europe

Abstract

This paper examines linkages among six major European government bond markets (Germany, France, Italy, UK, Belgium and the Netherlands) during 1988–2003. There is weak evidence that a stable long-run relationship exists among the six markets during the sample period. Granger causal linkages are generally not pronounced between the markets, while the contemporaneous correlation is strong between bond market innovations. Allowing for both Granger causal relationships and contemporaneous correlation, forecast error variance decomposition suggests that European bond markets are generally interdependent without a distinctive leadership. There is also some evidence that the UK and Italy may be less integrated with other markets, possibly due to their nonparticipation in the European Monetary System during part of the sample period.

Acknowledgement

The author would like to thank an anonymous referee of the Applied Financial Economics for many helpful comments, which substantially improve the paper. The author acknowledges financial support in the form of the College of Business summer research grant at Prairie View A&M University.

Notes

As documented in Holder (1999), 58% of the EMU bond market consists of government bond issues in late 1990s, compared with 25% for the US market. By contrast, EMU does not have a liquid corporate bond market. Corporate bonds in the EMU market have only accounted for 3% of the total market value, compared with 20% in the USA.

Sutton (2000, p. 368) also argued that bond yields display excessive comovements in major government bond markets, which may be captured by contemporaneous correlations between bond yield innovations. Also see the discussion below on the argument of Swanson and Granger (1997) that contemporaneous correlations may actually result from unidirectional Granger causality in the presence of temporal aggregation. Also noteworthy, strong contemporaneous correlations between international stock market innovations have also been documented in the literature (e.g., Bessler and Yang, 2003).

The J. P. Morgan data are available beginning from January 1986 for all markets except Italy, which is only available from January 1988 for Italy. As the Italian government bond market is considered important in Europe, it should be included in the study. Further analysis shows that the basic findings of this study are qualitatively not affected (results are available on request), whether Italy is included or not.

Thus far, the monthly data are usually the data of highest frequency available for the bond market indexes. Beginning from September 2003, J. P. Morgan started providing daily data from international government bond markets. Hence, it may be interesting to conduct research using daily data in the future.

We thank the referee for suggesting such analysis, which is largely ignored in the literature.

The different findings on cointegration between this study and previous studies might also be due to the difference in sample periods, different sets of markets under consideration, and different proxies for bond markets. For example, Barassi et al. (2001) used 10-year government bond rates rather than bond market indexes.

In addition, based on the first differenced VAR model as applied in the Granger causality test below, the CUSUM test does not show any sign of structural breaks, but the CUSUMSQ test suggests that two structural breaks might have occurred, one in 1990 (possibly related to the German reunification) and another in 2001 (possibly related to the establishment of the EMU). However, further analysis shows that the basic inference of this study should be robust. Recursive estimation is conducted on the VAR model. The inference on the statistical significance for each coefficient remains the same throughout the sample period (results are available on request). In addition, it is well known that the deterministic change would not affect the result on the forecast error variance decomposition.