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Liquidity or Volatility? Disentangling the Sources of Spillovers in Euro Area Sovereign Bond Markets

This paper examines the propagation of volatility and liquidity shocks across major sovereign bond markets during the euro area sovereign debt crisis. Spillovers are measured via a forecast error variance decomposition of a vector autoregressive model, which captures jointly the dynamics of liquidity and volatility in the government bond markets of Belgium, France, Germany, Italy, the Netherlands, and Spain. The model controls for common trends in sovereign credit risk, financial sector credit risk, funding conditions, aggregate default risk, and proxies for regional and global risk aversion. We show that liquidity is generally the more important source of shocks transmitted across borders, and this transmission largely originates from Italy and around the Italian crisis. Our findings highlight the importance of considering jointly liquidity and volatility dynamics in an analysis of spillovers beyond a traditional volatility spillover framework.