Confidence swings and sovereign risk dynamics

This study investigates the time-varying determinants of Italian sovereign risk using a Markov-switching structural vector autoregression, estimated on 1990–2018 monthly data. Sign restrictions are used for identification, and allow macroeconomic fundamentals and confidence-related factors to be characterized as separate and regime-dependent drivers of risk. We show that the latter becomes relevant during a crisis regime, when a negative confidence shock triggers demand-like macroeconomic disruptions, and sharp increases in sovereign spreads. Changes in fundamentals, that is, fiscal, supply and demand shocks, are unable to directly explain episodes of sovereign risk surges. Counterfactual simulations highlight the prevailing role of regime-dependent dynamics, where confidence switches tend to characterize the historical evolution of sovereign risk premia and reversals in spreads cyclicality.