Financial market volatility and economic policy uncertainty: bridging the gap

Prepared by Giulia Martorana and Jakub Mistak

Following the 2 April tariff announcement by the US Administration, financial market volatility spiked from previously subdued levels, becoming more aligned with the surge in economic policy uncertainty (EPU) observed since the autumn of last year. Chart A illustrates financial market volatility measures for the euro area (VSTOXX) and the United States (VIX) alongside the corresponding EPU indices. EPU indices are news-based measures of economic policy uncertainty that have gained in popularity for their ability to track major economic and political events.^[1] Since last autumn, EPU indices have surged on both sides of the Atlantic, with this upward trend continuing into 2025 amid enduring geopolitical risk and increasing uncertainty surrounding tariff policies. In contrast, financial market volatility in both the euro area and the United States remained relatively muted until March on the back of strong momentum in equity markets. However, both the VIX and the VSTOXX spiked following the equity market sell-off triggered by the announcement of US tariffs on 2 April.

Historically, measures of EPU and financial market volatility have displayed close co-movement, albeit diverging at times and across countries. Historically, disconnects between EPU and financial market volatility have emerged following significant events, such as the 2016 US presidential election, the UK Brexit referendum and the recent energy crisis. This has sparked a large body of research, which has offered various interpretations of the muted reaction of financial market volatility to changes in policy uncertainty. These include, for instance, a deterioration in the quality of political signals, differences in investor opinions and the role played by strong economic conditions.^[2]

The recent increase in euro area EPU reflects an intensification of an upward trend observed over a number of years. Since 2021 movements in euro area EPU have been heterogeneous across countries, with the indicators for Germany and France consistently remaining above their historical averages.^[3] Particularly striking is the upward trend in German EPU, which reached historical highs in April 2025 at the time of the US Administration’s tariff announcement (Chart B, panel a). For this reason, and for reasons of data availability, the analysis in this box focuses on Germany. A database of news articles is used to replicate German EPU.^[4] Specifically, the replicated index relies on a database of 1,857,207 German news articles spanning the period from January 2000 to April 2025 and closely tracks the original EPU index. When plotted alongside the index of German equity market volatility (VDAX), it is evident that the disconnect between the two measures observed from the autumn of last year and into the first three months of 2025 reflects an intensification of a trend observed over a number of years. This divergence persisted until early April, when a sharp rise in the VDAX, which coincided with the sell-off in global equity markets, brought it into line with the earlier increase in the EPU index.

A topic-based analysis of newspaper articles using a large language model (LLM) identifies domestic and global uncertainties as being behind the recent surge in German EPU. The analysis leverages the flexibility and contextual understanding of LLMs to extract different economic topics driving German EPU. Specifically, OpenAI’s GPT-4o is used to identify multiple topics within each newspaper article.^[5] Chart B, panel b), presents the six uncertainty categories identified. The main drivers of the increase in German EPU include domestic uncertainty, particularly related to politics and fiscal policy, and global uncertainty, captured by the geopolitical, energy and, more recently, trade categories. The rise in domestic and fiscal policy uncertainty reflects internal issues, including developments in the real economy, industrial policy, fiscal budget, political coalition dynamics and elections. Meanwhile, geopolitical risk intensified following Russia’s unjustified invasion of Ukraine and during the escalation of the conflict in Gaza. Energy-related uncertainty also surged in the wake of the Russian invasion of Ukraine, amplified by Germany’s heavy dependence on Russian gas at that time. Monetary policy uncertainty increased in line with post-pandemic inflation trends, as echoed by various market-based indicators. Finally, international trade uncertainty encompasses significant events and shocks, such as Brexit, the 2016 US presidential election, the COVID-19 pandemic and recent developments in US tariff policy, all of which tested global supply chain resilience.

A formal empirical analysis can help in understanding recent developments, including those following the US tariff announcement on 2 April, when the spike in financial market volatility aligned with persistently high levels of policy uncertainty amid a significant sell-off in equity markets. Drawing on US literature, this box examines whether the relationship between financial market volatility and German EPU has been affected by the “momentum” in the equity market, defined as the number of months with positive returns in the equity index over a given period. Specifically, the empirical analysis models implied volatility (“log⁡VDAXt”) as a function of the identified EPU categories.^[6] Chart C plots the marginal effects of increases in the six uncertainty categories on implied stock market volatility, conditional on equity market performance. In the six months to April 2025, the equity market recorded four months with positive returns (highlighted by the grey columns in the panels).

The results indicate that a disconnect between financial market volatility and EPU is more likely to emerge when equity market momentum is strong. Conversely, co-movement is more likely when that momentum is weak. These results hold across different categories and are robust across various specifications. This pattern is consistent with the growing disconnect between financial market volatility and the EPU index observed in the six months to February 2025, a period of particularly strong equity market momentum. Similarly, the same findings also explain the closing of the gap between financial market volatility and EPU following the US tariff announcement on 2 April. During this episode, the spike in volatility aligned with persistently high policy uncertainty on the back of a significant stock market sell-off. A possible interpretation of these findings is that political uncertainty commands a larger risk premium during periods of weaker stock market performance, particularly when the uncertainty is perceived to have significant implications for economic outcomes.