To analyze the relationship between global uncertainty and sovereign bond markets, we construct a monthly panel dataset for 19 countries from January 1990 to June 2018. As a measure of uncertainty, we consider the Economic Policy Uncertainty Index (EPU) (Baker, Bloom and Davis (2016)), which reflects uncertainty about fiscal, regulatory or monetary policy and it is constructed using the relative frequency of own-country newspaper articles that contain the trio of terms: economy (E), policy (P) and uncertainty (U). As financial indicators we consider the zero-coupon yield curve for government bonds with maturities 1 - 10 years.
In the first part of the analysis, we decompose each country’s EPU index into global and local (country-specific) uncertainty factors. The global factor is constructed as the GDP-weighted average of national EPU, and the local factor is obtained as a residual that reflects the domestic uncertainty that cannot be explained through the global factor. We find that countries differ in their exposure to the global factor and in the volatility of their local uncertainty. With these two measures uncertainty, in the second part of the analysis we study their differential effects on the government yield curve. We find that both sources of uncertainty are important in determining government yields; however, yields respond very differently to global and local sources of policy uncertainty.
Figure 1 shows a robust negative relationship between government yields and global uncertainty at all maturities, which is consistent with the response to an undiversifiable risk: when global uncertainty is higher, capitals fly away from risky investments towards safe assets, pushing yields down in all countries. In contrast, we find an heterogeneous response of government yields to local uncertainty (both negative and positive ‘betas’, which are more dispersed for longer maturities). This result suggests that, in some countries, higher local uncertainty shifts capital towards their own governments bonds, whereas in other countries, capital flies across the border towards foreign bonds. This heterogeneous cross-country flight-to-safety phenomenon is a novel result, and it is robust to including additional measures of global risks and global recessions.
In order to explain the heterogeneous responses to local uncertainty, we correlate the response of government yields with different economic, financial, and institutional characteristics of a country, such as financing costs, bond market liquidity, financial depth, and governance quality. We discover that these characteristics are important determinants of the heterogeneous responses to local uncertainty.
Figure 2 shows that cheaper financing costs, higher liquidity, stronger financial depth and better governance favour the role of a country’s government bonds as a safe-haven against local uncertainty.
The project has been presented at universities, central banks and other research institutions. I organized the Workshop “Uncertainty in Macroeconomics and Finance” where a large group of researchers discussed about the effects of uncertainty in global financial markets and trade networks, asset markets, labour markets, monetary and fiscal policy, as well as advancements in the measurement of uncertainty at national and international levels.
