We use a vector-autoregression, with parameter estimates corrected for small-sample bias, to decompose US and German unexpected bond returns into three 'news' components: news about future inflation, news about future real interest rates, and news about future excess bond returns (term premia). We then cross-country correlate these news components to see which component is responsible for the high degree of comovement of US and German bond markets. For the period 1975-2003 we find that inflation news is the main driving force behind this comovement. When news is coming to the US market that future US inflation will increase, there is a tendency that German inflation will also increase. This is regarded bad news for the bond market in both countries whereby bond prices are bid down leading to immediate negative return innovations and changing expectations of future excess bond returns. Thus, comovement in expected future inflation is the main reason for bond market comovement.
International Review of Financial Analysis, 2007, Vol 16, Issue 2, p. 172-182
International bond markets; VAR model; Return variance decomposition; Small-sample bias; Bootstrap simulation