1. Convergence and Anchoring of Yield Curves in the Euro Area Conference on International Financial Integration Federal Reserve Bank of Atlanta November 30, 2007 Michael Ehrmann European Central Bank Note: The views expressed in this presentation are the authors’ and do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco or the European Central Bank. Marcel Fratzscher European Central Bank Refet Gürkaynak Bilkent University Eric T. Swanson Federal Reserve Bank of San Francisco

2. Feb 1992: Maastricht Treaty signed Sep 1992: ERM crisis, several countries abandon exchange rate pegs May 1998: Countries eligible for EMU are announced Jan 1, 1999: Exchange rates irrevocably fixed, European Central Bank established, financial institutions adopt euro Jan 1, 2002: Euro adoption completed, currency issued European Monetary Union: Background

3. Two related issues: Convergence of sovereign bond yields (market integration) Convergence and anchoring of inflation expectations Despite unified monetary policy, convergence in these respects is not clear: Bond market unification: Default risk varies across sovereign governments Liquidity varies across bond issues Long-term inflation expectations: There may be probability of exit from EMU Overview of the Paper

4. Three metrics for assessing convergence: Yield levels Yield volatility Yield sensitivity to news (conditional volatility) Focus on daily frequency bond market data More stringent test of convergence/unification/anchoring Two types of yields: Medium- and long-term yields (bond market integration) Far-ahead forward interest rates (inflation expectations) Overview of the Paper

5. Related Literature Studies of EMU on financial markets using monthly data: Beale, Ferrando, Hördahl, Krylova, and Monnet (2004) Manganelli and Wolswijk (2007) Analysis of EMU on macroeconomic convergence: Canova, Ciccarelli, Ortega (2006) Rogers (2007) Analyses using high-frequency data: long-term inflation expectations: Gürkaynak, Sack, and Swanson (2005), Gürkaynak, Levin, and Swanson (2007) effects of U.S. announcements on euro yields: Ehrmann and Fratzscher (2006), Ehrmann, Fratzscher, and Rigobon (2006), Goldberg and Klein (2007)

6. Data Daily bond yields for four largest euro area countries: Germany France Italy Spain Also consider one “control” (non-euro area) country: United Kingdom Sample periods: pre-EMU: 1993-1998 post-EMU: 2002-2006 For comparability across countries, use zero-coupon yields

7. Data: Yield Curve Estimation

8. Convergence of Yields: Levels Convergence takes place even before EMU UK exhibits little convergence relative to EMU countries

9. Convergence of Yields: Volatility sample contribution of:pre-EMUpost-EMU first PC.895.998 second PC.097.001 Table 4: Principal Components Analysis of 2-year Yields across Countries

10. Convergence of Yields: Sensitivity

12. Figure 3: Response of 2-year Yield to Macroeconomic Surprises

13. Convergence of Yields: Sensitivity Figure 4: Heterogeneity in the Effects of Macroeconomic Surprises

14. Long-Term Yields and Inflation Expectations Long-term bond yields not necessarily a good measure of inflation expectations: In response to a shock, short-term interest rates move Long-term yields are an average of the short-term rates over the life of the bond Long-term yields should exhibit some sensitivity to news

15. Long-Term Yields and Inflation Expectations

16. Far-Ahead Forward Rates To study anchoring of inflation expectations, it is better to use forward interest rates rather than long-term rates: For N large enough, we have:

17. Far-Ahead Forward Rates

18. Figure 5: Response of 9-year-ahead 1-year Forward Rate to Macroeconomic Surprises

19. Far-Ahead Forward Rates Figure 6: Heterogeneity in the Effects of Macroeconomic Surprises on the 9-year-ahead 1-year Forward Rate

20. Conclusions European Monetary Union appears to have led to a unified sovereign bond market, despite differences in liquidity and default probabilities across member countries Convergence in yield levels, volatility, and sensitivity to news Convergence in daily data as well as at lower frequency Evidence that EMU has led to convergence in long-term inflation expectations Inflation expectations in Italy and Spain seem to have benefited the most