DP9538 | Eurozone Sovereign Yield Spreads and Diverging Economic Fundamentals

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We construct daily real-time macroeconomic indices conditional on the rating of Eurozone countries. We uncover substantial explanatory power of our measures of economic fundamentals for yield dynamics beyond the traditional yield principal components. In particular, we find that the divergence in economic growth between AAA and non-AAA countries significantly explains the dynamics of sovereign yield spreads between the same groups of countries. The explanatory power of fundamentals is not subsumed by proxies of time-varying risk-aversion or by the perceived riskiness of the Eurozone banking sector. Finally, we cast this analysis of the Eurozone sovereign yields in an innovative term structure model, featuring our real-time macroeconomic factors conditional on country ratings.