Markets don't seem to be too worried about the dysfunction going on in Washington

AP Photo/Evan Vucci

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

The BlackRock Blog

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.

Another example of this dynamic occurred two years later during the disputed 2000 U.S. election. In the fall of that year, U.S. policy uncertainty spiked along with the VIX Index, which nearly doubled from the summer lows. Not only was the U.S. faced with an unprecedented hung election, but the Federal Reserve (Fed) had been tightening in the 18 months leading up to the election. At the same time, credit spreads were up over 200 basis points (in other words two percentage points) even before the election.

Today we have the opposite set of conditions. Yes, policy uncertainty has increased and the Fed has been raising rates, but broader financial conditions are easier than they were at the beginning of the year: High yield spreads are tighter, the U.S. dollar is down and the stock market is having a stellar year. As a result, composite indicators of financial stress, such as the Bank of America Merrill Lynch Global Financial Stress Indicator, suggest less stress than in January.

What could change this happy state of affairs? A few possibilities. One is that policy uncertainty morphs into systematic stress—i.e. failure to raise the debt ceiling later this year. A more likely catalyst would simply involve tighter financial conditions, potentially a result of the simultaneous withdrawal of monetary accommodation by the Fed and the European Central Bank (ECB).

But as long as money remains relatively cheap and plentiful, investors are likely to stay unperturbed by political paralysis and dysfunction. When that starts to change, political uncertainty may suddenly morph back from farce into tragedy.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

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