With the elimination of foreign exchange risk among the E.M.U.-member countries, the yield of, say, French benchmark government bonds (henceforth, the yield) should be equal to that of German bonds, plus some credit and liquidity premia. Since both premia are not likely to change substantially from one day to the other, the yield should move in tandem with the German one and the corresponding spread should remain relatively stable. Yet, the yield exhibits a small but economically and statistically significant undershooting in response to changes in the German one, as a result of which the spread tends to decline when the latter increases, and vice-versa. We propose that the undershooting is the product of lagged adjustment in the European bond portfolios that is driven by liquidity considerations and, in particular, by the possibility of excessive bond-price movements in response to changes in the German yield. The empirical results are consistent with this proposition and additionally suggest that the adjustment can last for as long as four days.
Benchmark Government Bonds E.M.U. Credit and Liquidity Premia Bid/Ask Spread