"Shocks to U.S. short-term interest rates exert a substantial influence on euro area bond yields and equity markets, and in fact explain as much as 10 percent of overall euro area bond market movements."

One of the hallmarks of economic globalization is the growing integration of financial markets, both within and across countries. Yet, while it has become a truism that what happens in markets abroad matters for markets at home, and vice versa, the extent and complexity of global financial integration remains hard to identify and to quantify.

In Stocks, Bonds, Money Markets, and Exchange Rates: Measuring International Financial Transmission (NBER Working Paper No.11166), the key argument of co-authors Michael Ehrmann, Marcel Fratzscher, and Roberto Rigobon is that one needs to model all relevant financial assets simultaneously, domestically as well as internationally, in order to measure accurately and to fully understand the extent of financial linkages. The main limitation the literature has faced in measuring the propagation channels of financial linkages has been that asset prices are simultaneously determined. Ehrmann, Fratzscher, and Rigobon estimate the propagation of shocks using a novel technique that allows them to take into account the contemporaneous financial transmission within as well as between the two largest economies in the world - the United States and the euro area. The empirical model concentrates on daily returns over a 16-year period of 1989-2004 for seven asset prices: short-term interest rates, bond yields and equity market returns in both economies, as well as the exchange rate.

The authors discover notable differences in the interplay of domestic financial markets between the two economies. U.S. short-term rates react to developments in U.S. equity markets, with an increase in equity returns leading to higher short-term rates. In the euro area, by contrast, there is no significant relationship between equity markets and short-term interest rates. The authors note that this finding is "arguably quite intuitive," because it implies that "U.S. monetary policy is more responsive to equity markets than the monetary authorities in the euro area." Furthermore, there is evidence for a much larger response of stock markets to changes in monetary policy in Europe. Equity prices fall by around 0.75 percent in the United States, and by more than 2 percent in the euro area in response to a 100-basis point increase in domestic short rates.

Another interesting result relates to differences in the reaction of U.S. and European exchange rates to movements in domestic interest rates. A 100 basis-point increase in U.S. short rates leads to a 1.7 percent appreciation of the U.S. dollar, whereas an equally sized increase in European short-term rates produces a much larger appreciation, 5.7 percent, in the European exchange rate. "One possible explanation for such a difference is that the euro area economy is a more open one compared to the United States," the authors argue, "although the difference in the point estimate is nevertheless striking."

Looking at international transmission, the results of the work by Ehrmann, Fratzscher, and Rigobon underline the importance of international spillovers, both within asset classes and across financial markets. Although the strongest international transmission of shocks takes place within asset classes, they find evidence that international cross-market spillovers are significant, both statistically and economically. For instance, shocks to U.S. short-term interest rates exert a substantial influence on euro area bond yields and equity markets, and in fact explain as much as 10 percent of overall euro area bond market movements. But the transmission of shocks also runs in the opposite direction as, in particular, short-term interest rates of the euro area have a significant impact on U.S. bond and equity markets. The paper shows furthermore that in almost all cases the direct transmission of financial shocks within asset classes is magnified substantially, mostly by more than 50 percent, via indirect spillov ers through other asset prices.

Finally, the authors conclude that an important share of the behavior of financial markets is explained by foreign asset prices. On average, about 26 percent of movements in European financial assets are attributable to developments in U.S. financial markets, while about 8 percent of U.S. financial market shifts are caused by European developments. The larger importance of U.S. markets is found particularly for equity markets; for instance, movements in U.S. stock prices trigger corresponding change in the euro area, with more than 50 percent of the U.S. market developments being reflected in euro area stock prices. By contrast, European equities have an insignificant impact on their American counterparts. "This confirms the central role that U.S. equity markets play in world stock markets," the authors note. The authors make the interesting observation that transnational financial links became stronger after the creation of the European monetary union in 1999, although evidence on that point is "only sugg estive.

-- Carlos Lozada

The Digest is not copyrighted and may be reproduced freely with appropriate attribution of source.

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