Financial Market Volatility and Economic Policy Uncertainty: A Comprehensive Analysis

Financial market volatility in both the euro area and the United States surged following the US Administration's tariff announcement on 2 April, closely aligning with a rise in economic policy uncertainty (EPU) since the autumn of 2021. This alignment marks a significant departure from the historically close co-movement between EPU and financial market volatility, with the latter displaying a muted reaction to changes in policy uncertainty in recent times. A comprehensive analysis of German EPU reveals a rapid intensification of an upward trend observed over several years, with domestic and global uncertainties being the primary drivers behind the recent surge in EPU. Specifically, domestic uncertainty related to politics and fiscal policy, as well as global uncertainty captured by geopolitical, energy, and trade categories, have been identified as the main drivers of the increase in German EPU.

Key Takeaways:

• The recent increase in euro area EPU reflects an intensification of an upward trend observed over a number of years, with movements in euro area EPU being heterogeneous across countries.
• Germany has consistently recorded EPU indicators above their historical averages since 2021, with domestic and global uncertainties being the primary drivers of the increase in German EPU.
• 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, with domestic uncertainty related to politics and fiscal policy, as well as global uncertainty captured by geopolitical, energy, and trade categories, being the main drivers.
• The disconnect between financial market volatility and EPU is more likely to emerge when equity market momentum is strong, while co-movement is more likely when that momentum is weak.
• 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.
• A formal empirical analysis models implied volatility as a function of the identified EPU categories, with the results indicating that a disconnect between financial market volatility and EPU is more likely to emerge when equity market momentum is strong.

Statistics:

• Financial market volatility measures for the euro area (VSTOXX) and the United States (VIX) alongside the corresponding EPU indices have surged since the autumn of 2021.
• The VSTOXX index has increased by 25% since the US tariff announcement on 2 April, compared to a 20% increase in the VIX index.
• The EPU index for Germany has reached historical highs in April 2025, with domestic and global uncertainties being the primary drivers of the increase.
• The replicated EPU index has closely tracked the original EPU index, with the two measures displaying a high degree of correlation.
• The analysis leverages a database of 1,857,207 German news articles spanning the period from January 2000 to April 2025.
• The topic-based analysis of newspaper articles using a large language model (LLM) has identified domestic and global uncertainties as being behind the recent surge in German EPU.

Sources:

• Baker, Bloom and Davis, Bloomberg and ECB staff calculations.
• Dow Jones Factiva.
• ECB staff calculations.
• OpenAI's GPT-4o.