Stock volatility reactions to economic policy uncertainty: the moderating role of sentiment divergence

What accounts for the inverse relationship between Chinese stock market volatility and policy uncertainty during some periods? We investigate the underlying factors contributing to this phenomenon. Our research suggests that sentiment divergence significantly diminish the positive impact of policy uncertainty on stock volatility. In some periods, the positive effect of policy uncertainty on stock volatility may be relatively weak, unable to counterbalance the negative influence of sentiment divergence. As a result, we observe a reverse movement of stock volatility and policy uncertainty during these periods. Notably, we find that the moderating effect of sentiment divergence can persist for up to 25 days, which we attribute to liquidity constraints. Our research also indicates that the effect of sentiment divergence is larger for liquid stocks or under poor market conditions. Through a range of endogeneity and robustness tests, we verify the validity of the findings.