Be careful – or the big bad market will hike your interest rates

When will the big bad market come: if a country implements too little austerity, or if economic growth falters? Soon after the fall of the Dutch government (because the freedom party withdrew support for the minority government), the Dutch Central Bank published on its website a short analysis of Dutch – German bond spreads. They argued that the spreads increased as a direct consequence of the fall of the government. The supposed conclusion: the government budget should be put into order as soon as possible. Here’s the Dutch-German bond spread since 1987. It looks pretty high.

But the claim raises two questions. First, did the spread between Dutch and german interest rates really react to the news or was the larger spread just coincidence? In reality, bond prices jitter around all the time. What are the chances that the movement after the fall of the Dutch government were due to accident? The graph below shows the change in the spread between the 10-year Dutch and German treasury bonds and probability distribution associated with those changes. If we look at changes outside a 99.5% confidence interval, the day the Dutch cabinet fell, the 23rd of april, with a jump in the spread of 0.155 classifies as a significant event. The very next day, by the way, prices dropped by 0.136 percent.

The second question is what did markets actually react to? Did they react to a potential worsening of government budget or to a potential deterioration of growth prospects? In her presentation for the IMF on lessons from the crisis for fiscal policy, Christina Romer provided an interesting analysis for Spain. She made an overview of the ten largest increases in Spanish interest rates and coupled them to the information arriving in the market that caused these interest rate hikes. She concludes that news on a lack of fiscal consolidation as well as news on deteriorating growth prospects were associated in roughly equal proportions with the movements in interest rates.

In the period after 1-1-1999 there were 20 days with upward or downward jumps in the interest rate that were equally significant. Here’s the list.

The conclusion seems to be that Dutch bond prices did indeed increase after the government fell. To attribute jumps in spreads to a lack of austerity measures, however,  is a bridge too far. Bonds spreads might just as well have reacted to a perceived drop the probability of reform measures being enacted. Or to a temporary increase in uncertainty. Who knows.

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