When Policy Noise Becomes Market Waves
“If you see a dam leaking, do not wait for it to burst,” goes an old engineer’s maxim. In financial markets, policy uncertainty often begins as a trickle such as minor skirmishes over tariffs or election rhetoric. But it can quickly flood asset prices. Recent research from the European Central Bank highlights how measures of economic policy uncertainty (EPU), drawn from news sentiment, spiked this spring following the US tariff announcement back in April. Yet volatility in both equities and bonds only rose sharply once that uncertainty fed through to weak equity market momentum.
This disconnect between policy noise and market choppiness is not new. Studies have documented long stretches (such as after the 2016 US election or during the energy crisis) when EPU surged but volatility stayed muted. ECB authors show that in Germany, EPU rose steadily into early 2025, driven by domestic fiscal questions and global trade tensions, yet equity‐market volatility diverged until the sudden sell‐off in April realigned the two. Additional academic work suggests that strong prior equity gains lull investors into complacency, suppressing implied volatility even as policy risk mounts.
Today, with autumn under way, policy uncertainty remains elevated on both sides of the Atlantic, from looming US elections to fractious EU budget talks. Yet headline VIX and VSTOXX readings trade near multi‐month lows, suggesting another potential mismatch. The danger is that a fresh shock arising from a market comment by a central bank governor or a sudden credit‐rating downgrade could trigger volatility clustering, where initial jitters cascade across asset classes.
For advisers, the lesson is twofold. First, recognise that EPU indices and realised volatility often co‐move only when equity momentum fades. Monitoring both news‐based uncertainty measures and market breadth indicators can flag when the dam’s wall is weakening. Second, tilt portfolios towards assets with negative sensitivity to broad volatility spikes. Low‐beta equities, inflation‐linked bonds and select investment‐grade credit historically outperform during clustered sell‐offs. A modest allocation to defensive sectors such as utilities or consumer staples can also cushion portfolio drawdowns when policy noise turns into market turbulence.
Ultimately, markets adapt by repricing risk. The real flood comes when leaks become uncontrollable, and those who built windmills rather than walls long before, will weather the storm more easily.
If you would like to receive The Daily Update to your inbox, please email markets@epicip.com or click the link below.