High Policy Uncertainty and Low Implied Market Volatility – an Academic Puzzle?

Abstract

Motivated by the extremely low level of the CBOE VIX accompanied by the high level of US economic policy uncertainty in the period of late 2016 to the end of 2017, we examine the factors affecting the relationship between market volatility and economic policy uncertainty in the United States and the United Kingdom. Our analysis shows that low-quality political signals, higher opinion divergence among investors, and exceptional equity market performance consistently weaken the positive relationship between implied market volatility and policy uncertainty. Our findings help to explain the divergence between the market volatility index and economic policy uncertainty post the 2016 US presidential election and the UK Brexit referendum.

Keywords: VIX, VTSE, Economic policy uncertainty, Baker-Bloom-Davis index, Quality of political signals, Investor sentiment, Bullish market, Investors’ opinions

JEL Classification: G11, G14, G23, G41