Evolution of International Stock and Bond Market Integration: Influence of the European Monetary Union

Abstract

This paper examines the dynamic relationship between daily stock and government bond returns of selected countries over the past decade to infer the state and progress of inter-financial market integration. We proceed to empirically investigate the influence of the European Monetary Union (EMU) on time-variations in inter-stock-bond market integration/segmentation dynamics using a two-step procedure. First, we document the downward trends in time-varying conditional correlations between stock and bond market returns in European countries, Japan and the US. Second, we investigate the causality and determinants of this interdependent relationship, in particular, whether the various macroeconomic convergence criteria associated with the EMU have played a significant role. We find that real economic integration and the reduction in currency risk have generally had the desired effect on financial integration but monetary policy integration may have created uncertain investor sentiments on the economic future of the European monetary union, thereby stimulating a flight to quality phenomenon.

Keywords: Euro, volatility, currency unions, stock-bond correlations, time-varying financial market integration, flight to quality, optimal currency area

JEL Classification: C32, E44, F3, G14, G15