Pandemic Shocks and Fiscal-Monetary Policies in the Eurozone: COVID-19 Dominance During January - June 2020

Abstract

This case study compares the importance of prevailing market factors against that of COVID-19 dynamics and policy responses in explaining the evolution of Eurozone (EZ) sovereign spreads during the first half of 2020. Focusing on daily Eurozone CDS spreads, we adopt a multi-stage econometric approach. First, we estimate a multi-factor model for changes in EZ CDS spreads over the pre-COVID-19 period of January 2014 through June 2019. Then, we apply a synthetic control-type procedure to extrapolate model-implied changes in the CDS from July 2019 through June 2020. We find that the factor model does very well in tracing the realized sovereign spreads over the rest of 2019, but breaks down during the pandemic-diverging substantially in March 2020. In the second stage, focusing specifically on the 2020 period, we find that the March 2020 divergence is well accounted for by COVID-specific risks and associated policies. In particular, mortality outcomes and policy announcements, rather than traditional determinants like fiscal space and systematic risk, drove CDS adjustment over this period. Daily CDS spread widening ceased almost immediately after the ECB announced the PEPP, but the divergence between actual and model-implied changes persisted. This divergence can be traced back to the fact that fiscally secure EZ Core countries saw spreads widen further than implied-comparable to the widening of more fragile countries-as several of the Core countries were hit hard by COVID-19. Taken all together, this points to COVID-19 Dominance: The widening spreads during the pandemic induced by COVID-specific risks and fiscal responses has led to unconventional monetary policies that primarily aim to mitigate the short-run fear of the worst economic outcomes, temporarily pushing away concerns over fiscal risk.

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