Fiscal policy and government bond yields: New evidence from the EU

Abstract

We investigate the impact of fiscal deficits, sovereign debt, and other fiscal variables on the country-specific component of 10-year government bond yields. While existing studies highlight the influence of fiscal stance on yields, they do not explicitly examine the country-specific component. Using a Global Factor Model, previously applied to stock returns, we isolate the country-specific component from global and regional factors and employ it as the dependent variable in panel models for European Union countries. We find that the component rises with fiscal imbalances, particularly when sovereign debt is high, economic sentiment weak, institutional quality poor, or foreign capital exposure significant. Cuts in current expenditure or increases in indirect taxes lower the component, while changes in government investments or direct taxes have no effect. The findings highlight the non-linearities in yield determination and the importance of fiscal adjustment composition, offering insights to mitigate sovereign borrowing costs.