Term premia and short rate expectations in the euro area

Identifying the components of yields is a challenging task for monetary authorities. We use a term structure model with stochastic volatility and eurozone global macro factors to estimate time-varying term premia and short rate expectations for ten countries in the euro area. Unlike previous studies, we explicitly disentangle from these components the convexity effects that have substantial impact on long-term yields in turbulent times. The empirical evidence shows that term premia are significantly positively related to yield volatility across all countries, while term premia and expected short rates react in opposite directions to shocks in eurozone inflation and GDP growth expectations. A connectedness analysis based on variance decomposition suggests that there exist significant cross-country interconnections for the yield components, with the size of the links varying substantially over time and across countries.