Macroeconomic Determinants of Sovereign Credit Risk

Abstract: This report analyzes the macroeconomic determinants of sovereign bond yields in three different economies: the US, a large open economy and a benchmark in the financial markets, Sweden, a small open economy that has successfully dealt with financial crisis, and Italy, a large open economy with a history of financial distress. Cointegration techniques of the VECM and the ARDL model were used to derive the short-run and the long-run determinants of sovereign bond yields. The results show that for the US, Sweden, and Italy the macroeconomic fundamentals explain in aggregate 3.9%, 38.2%, and 66.1% respectively of the variation in yields. With inflation as the leading variable for Sweden and debt to GDP for Italy. Two important conclusions are deduced from this data: firstly, macroeconomic fundamentals in countries with higher perceived riskiness have more influence on investment decisions in the financial markets and secondly, investors pay attention to different macroeconomic variables depending on the country. The results also explain how the US have benefitted from “safe haven” flows, as the fundamentals show relationships with yields that are contradictory to economic theory.