No. 322 - Long-Term Interest Rate Convergence in Europe and the Probability of EMU

Using a simple method, based on forward interest spreads, we analyse the recent movements in the 10-year yield differentials between three currencies (Italian lira; Spanish peseta; Swedish krona) and the DM in order to gauge the extent to which the reduction in these differentials was due to market arbitrage triggered by the expectation of EMU or to more "fundamental" factors (lower inflationary expectations; improved fiscal outlook). We find that most of that reduction cannot be directly explained by EMU expectations, though EMU is likely to have had an indirect influence by providing an incentive for faster convergence on inflation and fiscal performance. As a by-product of our analysis, we compute estimates of the market probabilities of EMU taking place and of each country joining at different dates (1999 and 2002).