Policy Uncertainty in Australian Financial Markets

Abstract

Economic policy touches most facets of corporate decision-making and variations in policy can elicit significant changes in financial performance and asset prices. We utilise the EPU measure of Baker et al. (2016) to investigate the extent to which policy uncertainty influences Australian financial market returns. Our empirical results demonstrate that both domestic and global uncertainty have a significant negative impact on excess stock returns, changes in bond yields and AUD returns. The relationship is concentrated in the left tail of the return distribution and largely driven by increases in policy uncertainty. Although the identified relationship is negative throughout the sample period, the magnitude of the relationship appears to be state dependent and is influenced by periods of high uncertainty, recession, and the lead-up to federal elections. The most plausible explanation for our results is that uncertainty about economic policy is channelled to financial markets via the discount rate effect, resulting in a higher risk premium. Our results are important for investors, corporate managers, and policy makers wishing to navigate periods of policy uncertainty.

Keywords: Economic Policy Uncertainty, Australian Financial Markets, Stock Markets, Bond Yields, Political uncertainty

JEL Classification: G10, G12, G14, G15