Britaly?: identifying euro area historical analogues to the UK'S 2022 bond market shock

Abstract

Comparing the UK's 2022 sovereign debt crisis with earlier European examples is crucial for a holistic understanding of how such crises emerge and evolve to better comprehend the warning signs of sovereign distress and the importance of coherent and credible economic governance. Both crises were marked by sudden and severe shifts in investor confidence. The UK government's "mini budget" announcement on September 23, 2022, sent yields on UK gilts soaring at a daily rate not seen since the 1990s. Similarly, official disclosure by Papandreou's government regarding the actual state of Greece's public finances on October 20, 2009, caused daily sovereign debt yields in some euro area countries to rise to levels not seen since joining the euro. The primary objective of this paper is to conduct a comparative econometric analysis of the euro area sovereign bond market, with the goal of identifying past episodes similar to the turmoil experienced in the UK government bond market during September-October 2022. This comparative perspective aims to provide valuable insights for future crisis prevention in an increasingly interconnected global financial system. Specifically, we use daily data on 10-year government bond yields from January 3, 2000, to June 30, 2023, and apply both univariate and multivariate nearest neighbours' techniques. We also introduce a novel methodology, k-Related Simultaneous Nearest Neighbours (k-RSNN), which offers significant advantages over traditional forecasting models such as ARIMA and GARCH (it enables simultaneous analysis of multiple sovereign bond markets, effectively capturing cross-country dynamics, detecting nonlinear patterns and structural breaks, and identifying past events similar to recent crises). Our results show that financial markets initially interpreted the UK bond market disruptions between October 17 and 31, 2022, as comparable to the fiscal credibility crises faced by Spain and Italy during the European sovereign debt crisis. However, after the Bank of England's targeted intervention, perceptions of the UK's fiscal credibility shifted toward alignment with core euro area countries. Finally, from January 16 to June 30, 2023, we find strong parallels with the sovereign-bank risk nexus that previously affected Spain and Italy during the euro area crisis. Our findings indicate that although the origins of the crisis in the UK and the euro area are different (lack of fiscal credibility and poor communication vs. solvency concerns, weak banking systems, and limitations of incomplete economic unions), examining them together offers valuable lessons: policymakers should better recognise early warning signs of sovereign distress and reinforce the importance of coherent and credible economic governance.