Financial market Volatility, macroeconomic fundamentals and investor Sentiment

In this paper, we investigate the dynamic relationship between financial market volatility, macroeconomic fundamentals and investor sentiment, employing a two-factor model to decompose volatility into a per- sistent long run component and a transitory short run component. Using a structural VAR model with Bayesian sign restrictions, we show that adverse shocks to aggregate demand and supply cause an in- crease in the persistent component of both stock and bond market volatility, and that adverse shocks to the persistent component of either stock or bond market volatility cause a deterioration in macroeco- nomic fundamentals. We find no evidence of a relationship between the transitory component of volatil- ity and macroeconomic fundamentals. Instead, we find that the transitory component is more closely associated with changes in investor sentiment. Our results are robust to a wide range of alternative spec- ifications. Out-of-sample forecasting shows that the components of volatility can improve forecasts of macroeconomic fundamentals, and vice versa.