EU Sovereign Bond Yield and Deviation from Lon-run Equilibrium

The aim of this thesis is to empirically investigate the dynamic relationship between sovereign bond yields, macroeconomic fundamentals and risk proxies for each of 7 different Euro Area (EA) members between 2000 and 2014. In order to uncover the long-run equilibrium effect of a set of independent variables on sovereign bond yields, I utilize a multivariate Vector Error Correction Model. To gauge the time duration of deviations from their respective long-run sovereign bond yield level, an Impulse Response Function is used. The main finding is that each country’s sovereign bond yield has a significantly different dynamic relationship with underlying fundamental characteristics. In fact, during periods of economic uncertainty and/or economic distress, the relationship between sovereign bond yields and underlying fundamentals can alter drastically and almost instantaneously. The effect of exogenous shocks can alter the underlying relationship with sovereign bond yield to such an extent that the propagation of the yield movement has altered its long-run pathway. This process of deviation adjustment can persist for an extended period of time and is marked by fluctuating sovereign yields with oscillations of different magnitude around the long-run equilibrium. Finally, Dynamic OLS models will give further evidence for the lack of coordinated coherence in the relationship between fiscal/macroeconomic fundamentals and sovereign bond yields