Financial risk, risk appetite, and sovereign spreads

With the change in Fed policy, the deterioration of financial conditions, and the mixed US yield curve signals, there will be widening of sovereign bond spread and greater differentiation between country yields. Changes in the risk appetite of financial institutions that are the underwriters of sovereign debt will spill-over to market prices regardless of the current account fundamentals. 

Using an excess bond premium (EBP) model and a Global Financial Cycle (GFC) model, researchers have found a clear link with sovereign spreads, "Global financial risk factors and sovereign risk". 

The EBP model looks at US corporate bond spreads net of default risk as a signal of risk appetite. The GFC factor model focuses on US monetary policy tightening as the key to deleveraging of financial intermediaries, a decline in domestic credit and tightening of foreign financial conditions and credit flows. Tightening US monetary conditions, given the role of the dollar, will have an international transmission effect that is different than the credit and risk-taking channel.

A continual and sharp tightening of US monetary policy will translate into high sovereign bond spreads. It has already started and will continue. Can it lead to the 2008 spreads? Unlikely, given there was banking crisis at the same time; however, a sustained level of spread widening is realistic given over 200 bps of Fed tightening expected.