Why Investors Are Ignoring Political Dysfunction—for Now

Russ discusses an enigma: Stocks continue to climb higher and volatility is at all-time lows while disarray reigns in Washington.

At this stage of the bull market, investors are contending with more than a few enigmas: Do valuations even matter? Will interest rates ever rise? And how do you explain the divergence between U.S. political dysfunction and the unnatural calm in financial markets?

That last one has become particularly troubling. Most volatility measures are near all-time lows while Washington appears in complete disarray. Nonetheless, investors are likely to continue to look past political dysfunction, at least as long as financial conditions remain this easy.

Back in May, I first wrote about the relationship between policy uncertainty and market volatility. As a proxy for political uncertainty I used the popular Economic Policy Uncertainty indexes, measures based on real-time news flow. At the time I suggested that while market volatility and policy uncertainty do move in synch, the relationship is not particularly strong. Other factors, notably credit market conditions and the near-term economic outlook, tend to be more important.

Since then, U.S. economic policy uncertainty has only risen. Although the index has been higher during the past three months, overall policy uncertainty is significantly above where it was pre-election. And yet the VIX Index, a common measure of equity market volatility, is at half of its November peak (see the chart below) and bond market volatility is about a third lower. As surreal as this seems, it is not inconsistent with history.

VIX Volatility Index


History lessons

In the past, policy uncertainty has been more likely to coincide with a significant spike in volatility when monetary and financial conditions were tightening. This was the case in the summer of 1998, during the emerging markets crisis. While the federal funds target rate was stable, credit markets had been tightening financial conditions since the beginning of that year.