By Tim Condon

Financial market volatility has been historically high in the three years since the Global Financial Crisis. Perhaps surprisingly, it has not been uniformly positive or negative for risk assets. Global equities gained 27 percent in 2009 and 10 percent in 2010 but are down 7 percent in 2011.

Economic policy and expectations for policy have principally determined the performance of risk assets since the GFC. They have been the main source of high financial market volatility.

In normal times economic policy isn’t a source of volatility. By “normal times” we mean when spending _ nominal GDP _ is on its long-term trend path. In normal times economic policy is predictable. “Real” shocks, for example to tastes or technology, are the principal sources of volatility. They are irregular and tend to be infrequent.

Economic policy becomes a huge source of shocks when the spending is knocked far off its trend path. This happened during the global financial crisis. For example, by the third quarter of 2011 the U.S. spending was an unprecedented 13 percent below trend. Bernanke’s claim that the Fed was not “out of ammunition” at the zero bound implied it could loosen monetary policy sufficiently to close the gap. Its actions, however, have alternately raised and dashed hopes.

Consider the Fed’s announcement in October 2008 that it would pay interest on bank reserves. The S&P 500 plunged 22 percent in the next five trading sessions. The crash finally halted in March 2009 when the Fed announced QE1. Stocks rallied 65 percent by year-end. Bernanke’s informal announcement of QE2 in his 2010 Jackson Hole speech triggered a 19 percent rally in the S&P 500 by year-end. Stocks dropped 5 percent in the three sessions after the Fed announced Operation Twist in September 2011.

The alternate waxing and waning of hopes for Fed easing explains why U.S. monetary policy has been a principal source of policy shocks since the global financial crisis. There are no similar hopes for the ECB, which actually hiked its policy rate two times in 2011. As in the U.S., the financial crisis knocked most of the Eurozone far below its trend spending path. Germany is the exception. Spending was running 4 percent above trend when the crisis struck and fell to 4 percent below. However, a strong recovery closed the spending gap by the end of 2010.

Things are different in the 70 percent of the Eurozone outside Germany. The financial crisis caused spending to fall far below trend but their recoveries have been anything but strong. By the third quarter of 2011 their collective spending was 14 percent below trend. Their performance since the crisis raised questions about the solvency of some members and a debt crisis ensued. Eurozone leaders’ struggle to achieve consensus on how to resolve the crisis has been the other principal source of policy uncertainty.

U.S. monetary policy uncertainty is bound to diminish. Either the Fed will ease significantly and spending recovers Germany-like to its trend path. Or peoples’ expectations about the economy’s potential will align with its diminished current performance. ING’s baseline scenario is that the second of these will prevail and growth expectations will be revised to a lower “new normal.” Historically low government bond yields in the U.S. are a sign that expectations are adjusting.

Policy uncertainty over the approach to resolving the Eurozone debt crisis also will diminish as the Merkel approach achieves consensus. After 12 EU summits this is finally happening. However, below-trend spending growth in most of the Eurozone makes it likely that growth anxiety will occasionally cause investors to doubt the robustness of the Merkel approach. Investors can expect volatility to spike when that happens.

As policy uncertainty fades economic fundamentals will increasingly drive financial asset prices. The fundamentals argue for U.S. equities to rally. Corporate profits are at an historic high in relation to GDP and stocks are cheap with the S&P 500 trading at a P/E ratio 25 percent below its historic average. Few world equity markets will be left behind in the resulting rally.