It was more or less by chance that Massimo Giuliodori and his fellow researchers discovered regular peaks in the yield curves of EU Member States. ‘We were doing research into how macroeconomic news affects yields in European countries. We noticed small movements that surprised us and for which we had no immediate explanation. It turned out that the small peaks coincided with moments in time when member states auctioned new government bonds’.
This observation resulted in an extensive study. In October 2018, in the Journal of Money, Credit and Banking, Giuliodori published a paper about this research under the title Cross-Border Auction Cycle Effects of Sovereign Bonds Issuance in the Euro Area. He wrote the paper together with UvA professor Roel Beetsma, Jesper Hanson of the IMF and Frank de Jong, Professor at Tilburg University. Giuliodori studied in Italy, obtained his PhD in Glasgow in 2003 and has been with the University of Amsterdam since the same year. In 2014, he was appointed Professor of Empirical Macroeconomics.
The auction cycle process
There is a close relationship between the primary market, in which new public debt is issued, and the secondary market, in which previously issued government bonds can be traded any time. The secondary market is the leading market, it could be argued, because it is on the secondary market that the prices of government bonds, and consequently government bond yields, are determined on an ongoing basis. When a government wants to auction a new loan, the interest rate must be about equal to the yield investors can get at that same moment on loans they can buy on the market.
The research by Giuliodori and his colleagues shows that the direction of cause and effect may sometimes be reversed and that yields are also determined by the activity on the primary market. ‘When a country auctions new government bonds, secondary market yields often rise in the preceding few days. In other words, investors therefore briefly drive up the yield, forcing the government concerned to accept slightly higher interest rates on the new loan than might have been expected on the basis of the market interest rates in the preceding period.’ In the days after the auction, the yields usually fall back to the level before the auction. Giuliodori calls this whole process the ‘auction cycle’.
‘We see that the spillover effect is stronger in stable times than during a crisis. The reason for this is that banks are less willing to take risks during a crisis.'
Interestingly enough, these cycles can be triggered by domestic as well as foreign auctions. ‘We see a high level of interaction between European member states when loans are auctioned somewhere: the spillover effect’, says Giuliodori, who investigated market movements in the Netherlands, Germany, Belgium, France, Spain and Italy since 1999. ‘When new loans are issued in one country, this can lead to a cycle in yields of up to a total of 5 basis points in other euro countries, with this cycle being measured from the lowest to the highest point. But an auction has the largest impact in the country holding the auction.’
An important explanation for these cross-border movements is the role and behaviour of the so-called primary dealers. These are banks that usually buy up the bulk of new government bonds and sell them on to end investors such as pension funds and insurers in the days following the auction. Many of these primary dealers operate in more than one country. In the Netherlands, for example, large foreign players such as Citigroup, Deutsche Bank and Santander operate alongside the Dutch Rabobank, ABN AMRO and ING. Giuliodori: ‘In the run-up to an auction, banks sell a part of the government bonds from euro countries that they still have on their books, in order to free up space for new purchases at the upcoming auction. As a result of these sales, yields rise.’
Less risk during a Crisis
The behaviour of banks operating as primary dealers also explains why the spillover effects differ over time. ‘We see that the spillover effect is stronger in stable times than during a crisis. The reason for this is that banks are less willing to take risks during a crisis, so they limit their activity as primary dealers in other countries and fall back on their home market’. At the same time, the yields in the country holding the auction may have a cycle of up to 20 basis points during a crisis.
‘Despite an earlier initiative by the European Commission, there is currently no effective coordination between Member States and for now.'
Such a cycle can be quite costly, as governments issue new loans to a total of tens of billions of euros every year. Twenty basis points equals 0.2 percentage points, which means that a 5 billion euro loan results in an additional annual interest charge of 10 million euros. When auctions of EU Member States follow each other in rapid succession, this can have a temporary upward effect on yields, so member states actually end up paying for the market distortions they cause each other.
Coordination between member states
Giuliodori would therefore prefer EU Member States to coordinate their auctions more closely, as this might prevent unnecessary interest payments. ‘Despite an earlier initiative by the European Commission, there is currently no effective coordination between Member States and for now, no solution seems to be forthcoming.’
Until then, says Giuliodori, member states should try to organise their auctions as flexibly as possible in order to keep costs as low as possible. ‘Countries such as the Netherlands and Germany publish annual and quarterly calendars that provide a general, advance overview of the kind and the timing of the loans they want to place. This gives investors something to go by and it builds trust, which in itself has a moderating effect on interest rates. At the same time, it is important that countries have the option to stop an auction at the last minute, or to adjust the maturity and volume of a loan when there is volatility in de sovereign bond market.’