Interest rate spreads in the Euro area: fundamentals or sentiments?

We analyze the determinants of interest rates on long-term government bonds within the Eurozone to assess whether the recent divergence in interest rates is attributable to changes in common economic fundamentals. First, we show that the panel approach, mostly employed by existing literature on this issue, has conceptual as well as empirical problems. Therefore we harness an event study approach using high-frequency (daily) data to investigate the impact of three categories of events on EMU government bond yields. Our results indicate that yields react to forecasts on key economic indicators such as growth and future budget deficits. In contrast, we do not find evidence that investors react to announcement of fiscal "bailouts" or austerity measures.