One of the many implications of rapid financial market globalization is the likelihood of increasing financial spillovers across countries. This is a particularly important possibility for government bonds, where the standardized characteristics of underlying instruments and rising internationalization of holdings are creating an increasingly interlinked and global market. Yields on government bonds provide the “risk free” interest rate that is the basis for returns in a wide swathe of other markets. Given that yields on long-term securities are generally considered to have a larger impact on activity than the short-term rates that monetary authorities target, globalized markets in government securities provide an important economic as well as financial link between countries.
In the past, one limitation in analyzing these links has been that it is difficult to separate real bond yields, which would be expected to be highly linked across countries, from changes in long-term inflation expectations, which would be heavily influenced by domestic monetary policy. Fortunately, the decomposition of nominal yields into these two components has been greatly assisted by the development of inflation-indexed bonds, which their movements to be continuously tracked. Although indexed bonds were already trading in a number of markets from the early 1990s, it is only with the introduction of inflation-indexed bonds in the United States—the world’s largest and most sophisticated bond market—in January 1997 that the potential to identify international spillovers in real interest rates and inflation expectations could be fully realized. With the U.S. inflation-indexed bond market now over a decade old, there is sufficient information to allow statistical analysis of spillovers in bond yields and inflation expectations.1
Accordingly, this paper uses government bonds to examine international spillovers between real interest rates and inflation expectations. It analyzes spillovers between the United States and six other industrial countries with inflation-indexed bond markets—Australia, Canada, France, Japan, Sweden, and the United Kingdom. Given the convergence of euro area bond yields since European Monetary Union, the French data (where inflation-indexed bonds were introduced in November 1998) can be taken as a proxy for the euro area as a whole. (Italian data, available since early 2004, are almost identical to the French series.) As a result, the sample covers bond yields in the vast majority of the industrial world, although in the case of Japan inflation-indexed bonds were only issued starting in 2004.
The focus of this paper is on bilateral links between the U.S. markets and other countries. This reflects the dominant position of the United States in the global bond market. Almost two-thirds of all private bonds are traded in U.S. markets, a significantly more important position than in the real economy, where U.S. GDP represents about one-third of the world using market exchange rates and 20 percent using purchasing parity rates. Financial markets are thus a potentially extremely important conduit for spillovers from the United States to the rest of the world.
Indeed, while this is the first paper we know of to examine international spillovers using inflation-indexed bonds, there is a large literature showing that U.S. macroeconomic news affects returns in foreign markets. Faust and others (2007) is a representative example. Using intraday data, they find that when U.S. economic activity turns out stronger than expected or there is a surprise monetary tightening, the dollar appreciates and interest rates in the United Kingdom and the euro area increase. Other works confirming this evidence on exchange rates include Almeida, Goodhart, and Payne (1998); Kim and Sheen (2000); Christie-David, Chaudhry, and Khan (2002); Fair (2003); Andersen and others (2003, 2007); and Ehrmann and Fratzscher (2003, 2005); Goldberg and Leonard (2003) and reach the same conclusions on interest rates. Andersen and others (2007) show how the impact on foreign equity markets varies depending on the state of the economy. Stronger-than-expected U.S. activity raises foreign stock prices during recessions but lowers them during expansions, when concerns about future monetary tightening appear to predominate.
Although U.S. economic releases move foreign markets, there are fewer spillovers in the opposite direction. The response of the German mark or euro-dollar exchange rate is rarely moved by German releases (Anderson and others, 2003 and Almeida, Goodhart, and Payne, 1998), and German and euro area data releases have little impact on U.S. bond yields (Goldberg and Leonard, 2003; Ehrmann and Fratzscher, 2005). In Becker, Finnerty, and Friedman (1995), U.S. news affects the U.K. equity market but U.K. news has no impact on the S&P 500.
The literature on linkages across financial markets also points to the dominance of U.S. spillovers to foreign markets, even when controlling for the role of macroeconomic news. U.S. interest rates drive interest rates in the euro area (Ehrmann and Fratzscher, 2005), Germany (Bremnes, Gjerde, and Soettem, 2001), Canada (Gravelle and Moessner, 2001), and Australia (Kim and Sheen, 2000). Fatum and Scholnick (2006) show that increased expectations of U.S. monetary tightening, as measured by rates on federal funds futures contracts, are associated with an appreciation in the dollar. And there is a higher degree of dependence of foreign equity markets on U.S. markets than vice versa (Becker, Finnerty, and Gupta, 1990; Lin, Engle, and Ito, 1994; and Diebold and Yilmaz, forthcoming). In a framework analyzing U.S.-euro area linkages across short-term interest rates, long-term bond yields, and equity markets, Ehrmann, Fratzscher, and Rigobon (2007) find that the share of variance in euro area markets explained by U.S. markets is, on average, three times as large as the euro area’s importance for U.S. markets.
There is also an active body of work on the interdependence of global real interest rates and their convergence over time, but none using inflation-indexed securities, due to the short period for which data exist. The extant literature typically uses ex post real rates based on inflation outturns, or derives real rates using proxies for inflation expectations. Overall, the evidence for real interest parity is mixed, while studies that examine the response of interest rates by country find some role for U.S. real rates in determining those of other countries.2 For example, Chinn and Frankel (2005) find that European rates move so as to restore real interest parity while U.S. rates do not, although there are preliminary indications that this is changing with the advent of the euro area. Cumby and Mishkin (1986) show that European rates respond to movements in U.S. rates, but reject real interest parity because the pass-through is not one-to-one. Breedon, Henry, and Williams (1999) find some evidence that U.S. rates are weakly exogenous for other G7 countries, but cannot reject the same hypothesis for Canada or France. In Chinn and Frankel (1995), U.S. and Japanese real rates have similar influences on emerging Asian markets, but there are no links between the U.S. and Japan or Canada. Thus, the use of more reliable data on real interest rates may clarify the nature of cross-country linkages.
Figures A1-A12 show impulse-response functions up to a horizon of 50 days. Interest rates and inflation expectations are expressed in percentage points. The figures show the response, in percentage points, of the first variable listed to a one standard deviation shock in the second variable listed. The ordering of the Cholesky decomposition used to identify shocks to each variable is RUS, PUS, R*, P* in Figures A1-A6; RUS, R*, P*, PUS in Figures A8, A9, A11 and A12; and R*, P*, RUS, PUS in Figures A7 and A10.