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As global economic uncertainty rises, so should market volatility

LiveMint logoLiveMint 12-06-2017 Livemint

Theresa May’s comeuppance in the UK elections is the latest in a series of political events that have increased economic uncertainty around the world. The gold standard in raising uncertainty, if it can be called that, is of course the shock election of Donald Trump as US President. The obvious question then is: shouldn’t the rise in uncertainty be mirrored in the financial markets?

The accompanying chart, taken from the World Bank’s Global Economic Prospects, shows the relationship between an index of Economic Policy Uncertainty (EPU) and the Chicago VIX, an index of volatility in the markets. As the chart shows, rises and falls in the VIX have closely tracked rises and falls in the EPU historically, until the Trump win. Paradoxically, the election of Donald Trump led to a fall in the Vix, or to lower market volatility.

It is very likely that the gap between the EPU and the VIX will be closed soon and the tight historical correlation between the two re-established by an increase in market volatility.

Says the World Bank report, “A further increase in policy uncertainty from already high levels could dampen confidence and investment and trigger financial market stress, after a period of unusually low financial market volatility. Market reassessment of advanced-economy monetary policy, or disorderly exchange rate developments, could contribute to swings in EMDE (Emerging Market and Developing Economies) asset prices and capital flows, potentially amplified by vulnerabilities in some countries.’

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