Explaining the Correlation Changes between the Risk-Free Rate and Sovereign Yields of Euro Area Countries

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We study the correlations between the risk-free rate and the sovereign yields of ten euro
area countries using smooth transition conditional correlation GARCH (STCC-GARCH)
specifications, which control for credit risk in mean and variance equations and condition
non-linearly on liquidity risk. We show that the correlations are state-dependent and heterogeneous
across jurisdictions. Using Panel Vector Autoregressive Regression models, we
identify the macro factors behind the correlation breakdown: interbank credit risk, the crisis
in Greece and break-up risk. Conversely, the ECB asset purchase programs helped restoring
the pass-through relationship. We also provide a methodological contribution by estimating
all STCC-GARCH parameters at once and by introducing an STCC-GARCHX.

Author(s):

Roberto De Santis    
European Central Bank
Germany

Michael Stein    
University of Duisburg-Essen
Germany