Pandemic shocks and fiscal-monetary policies in the Eurozone: COVID-19 dominance during January-June 2020

Abstract

We compare the importance of market factors against that of coronavirus disease-19 (COVID-19) dynamics and policy responses in explaining Eurozone sovereign spreads. First, we estimate a multifactor model for changes in credit default swap (CDS) spreads over 2014 to June 2019. Then, we apply a synthetic control-type procedure to extrapolate model-implied changes in CDS. The factor model does very well over the rest of 2019 but breaks down during the pandemic, especially during March 2020. We find that the March 2020 divergence is well accounted for by COVID-specific risks and associated policies, mortality outcomes, and policy announcements, rather than traditional determinants. Daily CDS widening ceased almost immediately after the European Central Bank announced the Pandemic Emergency Purchase Programme, but the divergence between actual and model-implied changes persisted. This points to COVID-19 Dominance - widening spreads during the pandemic has led to unconventional monetary policies that primarily aim to mitigate short-run fears, temporarily pushing away concerns over fiscal risk.