Liquidity and tail-risk interdependencies in the euro area sovereign bond market

The likelihood of severe contractions in an asset’s liquidity can feed back to the ex-ante risks faced by the individual providers of such liquidity. These self-reinforcing effects can spread to other assets through informational externalities and hedging relations. The paper explores whether such interdependencies play a role in amplifying tensions in European sovereign bond markets and are a source of cross-market spillovers.

Using high-frequency data from the inter-dealer market, the authors find significant own- and cross-market effects that amplify liquidity contractions in the Italian and Spanish bond markets during times of heightened risk. The German Bund’s safe-haven status exacerbates these amplification effects. The authors provide evidence of a post-crisis dampening of cross-market effects following crisis-era changes to euro area policies and institutional architecture. Moreover, they identify a structural break in Italy’s cross-market conditional correlation during rising political tensions in 2018, which significantly reduced liquidity. Overall, findings demonstrate 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.

Dargh Clancy is Principal Economist at the European Stability Mechanism, Peter G. Dunne is Advisor at the Central Bank of Ireland and Pasquale Filiani is Quantitative Risk Analyst at Allied Irish Banks.

The paper has received the ECMI Best Paper Award at the ECMI Annual Conference 2019, held in Brussels on 6 November.