Short- and Long-Run Sovereign Risk Uncertainty in U.S. Credit Default Swaps

Abstract

This paper decomposes sovereign risk uncertainty in U.S. credit default swap (CDS) spreads into short-run and long-run components. We employ a Bayesian dynamic factor model within a state-space framework to link observed CDS spreads and macro-financial variables to an unobserved latent risk factor. The short-run component, extracted from shorter-maturity CDS spreads, exhibits higher fluctuations and lower persistence, whereas the long-run component, derived from longer-maturity CDS spreads, captures greater persistence. Our empirical findings reveal that long-run uncertainty has a significantly stronger adverse impact on macroeconomic indicators, reducing consumption and industrial production more than short-run uncertainty. Notably, we document a negative relationship between long-run sovereign risk uncertainty and the Economic Policy Uncertainty (EPU) index, suggesting a key distinction between short-term policy volatility and long-term risk expectations. This result indicates that persistent sovereign risk uncertainty does not necessarily amplify short-term policy uncertainty; rather, it may trigger stabilization measures, such as fiscal consolidation or central bank interventions, as policymakers respond to heightened long-term risks. These findings underscore the importance of distinguishing between short-run and long-run sovereign risk uncertainty, offering a novel framework for macroeconomic analysis and financial stability assessment.