04 November 2019

Vox EU: Liquidity linkages in European sovereign bond markets can amplify fundamental economic shocks

This column documents significant own- and cross-market interdependencies between liquidity and tail risks that amplify shocks likely attributable to economic fundamentals. The findings demonstrate the potential for the provision of liquidity across sovereign markets to be vulnerable to sudden fractures, with possible implications for euro area economic and financial stability.

Stable sovereign bond markets are crucial to a well-functioning economy and financial system. But despite the importance of amplifications of sovereign bond market tensions related to flights-to-safety and sudden liquidity contractions, there is little direct empirical evidence of the transmission channels through which such catalysts for amplification operate.

Authors provide strong evidence of a two-way relationship between the perceived likelihood of liquidity contractions and the risks faced by individual liquidity providers in euro area sovereign bond markets. This validates the widely accepted view that “liquidity begets liquidity”, as described in Foucault et al. (2013), and confirms the fact that liquidity dry-ups and the associated risk of price drops can become self-fulfilling in a way that reduces market quality and amplifies turbulence. They provide evidence that such self-reinforcing effects can spread to other assets consistent with well-understood informational externalities (Cespa and Foucault 2014) and hedging relations (Dunne 2019).  An important aspect of their analysis indicates that these effects are further augmented by the ‘safe-haven’ status of the  German Bund.

They find evidence of a post-crisis dampening of cross-market effects following crisis-era announcements of changes to euro area policies and institutional architecture, proxied by the famous “do whatever it takes” speech by ECB President Draghi. They show how risks associated with the provision of liquidity (measured in terms of the expected size of the lowest quantile of returns – also called the 1% value-at-risk) are related across pairs of markets after a shock to absolute returns in one of the markets. The response of the 1% value-at-risk facing dealers in the Italian and German sovereign bond markets following a unitary shock to absolute returns in the Italian market after Draghi’s speech in July 2012 practically disappears (becoming statistically insignificant for both markets). This implies that the speech produced conditions in which dealers feel safe when they provide liquidity and one less prone to sudden liquidity contractions.

Overall, their findings demonstrate the potential for the provision of liquidity across sovereign markets to be vulnerable to sudden fractures, with possible implications for euro area economic and financial stability. In spite of substantial improvements in the euro area policy and institutional architecture, the 2018 disruptions show that national sovereign bond markets remain susceptible to market-driven amplifications of fundamental shocks that can spread beyond the local market.

Full article on Vox EU

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