Yield differentials between domestic government bonds reflect the market assessment of countries' relative financial prospects In Discussion Paper No. 1330, Research Fellows Carlo Favero, Francesco Giavazzi and Luigi Spaventa evaluate the determinants of the total interest rate differentials on government bonds between high yielders, namely Spain, Italy, Sweden, and Germany. In particular, the authors address the question of the relative importance of local and global factors in the determination of such spreads.

Two components of total yield differentials are identified and measured: one due to expectations of exchange rate depreciation; and another which reflects the market assessment of default risk. The paper proposes and discusses a measure of the exchange rate factors and of the default risk premium based on interest rates swaps. Overall the investigation provides strong evidence in favour of the existence of a common trend for the Spanish and Italian spreads on Bunds, which is not shared by the Swedish spread. Such trend is driven by international factors and is independent from country-specific shocks. Country-specific shocks are only relevant in explaining short-term cycles around the common stochastic trend.