Regime-dependent effects of macroeconomic uncertainty on realized volatility in the U.S. stock market

Evidence shows that high macroeconomic uncertainty leads to high stock market volatility. However, the relationship between macroeconomic uncertainty and volatility is much less clear when there are structural changes in volatility. We examine the relationship between macroeconomic uncertainty and realized U.S. stock market volatility using a heterogeneous autoregressive regime switching model. This allows both volatility and uncertainty to determine the regimes. Realized volatility is best characterized by a four-regime structure in which macroeconomic uncertainty predicts realized volatility across regimes and is a threshold that determines regime switches. This model delivers a significant improvement in volatility prediction over longer horizons. Decomposing uncertainty into ‘‘good’’ and ‘‘bad’’ components, we find volatility responds asymmetrically to these across all regimes, with bad uncertainty having a quantitatively large effect. Our results provide a deeper understanding of how macroeconomic uncertainty determines stock market volatility and how it impacts real economic activity through its impact on volatility.