What Drives Euro Area Financial Market Developments? The Role of US Spillovers and Global Risk

Abstract

Financial asset prices contain a rich set of real-time information on the economy. To extract this information, it is crucial to understand the driving factors behind financial market developments. In this paper, we exploit daily cross-asset price movements in a sign-restricted BVAR model to analyse the extent to which euro area and US yields, equity prices, and the euro-US dollar exchange rate are jointly driven by monetary policy, macro and global risk factors. A novelty is that we allow for cross-Atlantic spillovers while also accounting for the unique role of the US in the global financial system. Our results underline the importance of US spillovers and shifts in global risk sentiment for understanding the dynamics of euro area financial variables. Euro area shocks transmit much less to US financial markets in comparison, with global risk shocks being more important instead. Using the daily shocks as instruments in a Proxy-SVAR, we demonstrate that the transmission of financial market movements to the macroeconomy depends on the underlying driver, thereby illustrating why it matters to look into the driving factors in the first place.

China's Footprint in Global Financial Markets

“…We propose an empirical framework that jointly decomposes daily movements in Chinese and US financial asset prices into underlying drivers in the spirit of Brandt et al (2021), thereby aiming to better control for possible commonalities. After years of financial liberalisation, China's financial markets appear sufficiently reflective of economic conditions to extract information from their co-movement to identify the underlying shocks driving assets price correlations.…”

“…Several important decisions have been announced after markets closed on weekdays or during weekends. For that reason, we instead lean more towards the literature that has exploited daily cross-asset price correlations based on sign restrictions to understand the underlying drivers of financial asset price movements, such as Matheson and Stavrev (2014), Brandt et al (2021)…”

“…3 Third, we exploit the safe-haven role of the US dollar to identify a global risk shock. Similar to Brandt et al (2021), we assume that as risk sentiment improves, investors move away from safe assets such as US government bonds, which increases US yields and narrows the spread with Chinese yields (as US yields respond more to global risk shocks given the safe haven status of US assets). However, in contrast to other shocks where a narrowing yield differential would cause the US dollar to appreciate against the Renminbi, safe-haven flows out of US assets triggered by favourable risk sentiment are assumed to push the US dollar lower, in line with the literature (e.g.…”

“…the US, by contrast, Chinese shocks are found to not matter much, as shown in Panel B. US equity prices are dominated by US-specific shocks and global risks shocks,given the important role of the US economy in providing safe assets for the global economy in line withBrandt et al (2021). Only during the onset of the pandemic, negative macro risk shocks in China trickled through minimally to weigh on US equity prices, but were overshadowed by markets reassessing the US growth outlook at the same time.…”

“…Instead, we propose an empirical framework that jointly decomposes daily movements in Chinese and US financial asset prices into underlying drivers in the spirit of Brandt et al (2021), thereby aiming to better control for possible commonalities. Financial market data has been extensively used to extract information about the underlying drivers of markets in advanced economies such as the US (e.g.…”