What Happens When Volatility Parts from Fundamentals
In theory, exchange rates should move in line with economic "fundamentals" — growth, productivity, consumption. Yet for decades, economists have had to acknowledge a seemingly mysterious misalignment: currencies fluctuate much more (or less) than fundamentals warrant. This is known as the exchange rate disconnect puzzle.
But what happens if, instead of looking at levels — i.e., the actual values of exchange rates and consumption — we look at their volatility, i.e., how much these values vary over time? This is the question at the heart of a study entitled Volatility (Dis)Connect in International Markets by Massimiliano M. Croce (Department of Finance, Bocconi University; CEPR; Baffi and IGIER), together with Riccardo Colacito (University of North Carolina), Yang Liu (University of Hong Kong), and Ivan Shaliastovich (University of Wisconsin-Madison), published in Management Science.
From “disconnect” to uncertainty-led movements
Croce and his colleagues show that the “disconnect” is not only about levels, but also about variability: currency markets do not fully reflect the uncertainty of macroeconomic fundamentals. The authors write: “The volatility correlations are below one, but they are larger than the level correlations.” Translated: exchange rates and domestic consumption move partly together, but not enough.
Classical models would predict that exchange rate and consumption differentials should be perfectly correlated. In contrast to this theoretical prediction, the volatility of exchange rates is not perfectly connected to the volatility of the fundamentals.
Analyzing data from 17 advanced economies between 1971 and 2019, the researchers find that the average correlation between exchange rate volatility and consumption differentials is about 0.2, while for levels it is only 0.04. That is, much lower than 1. “This value is important because classical models would predict that exchange rate and consumption differentials should be perfectly correlated. In contrast to this theoretical prediction, the conditional volatility of exchange rates is not perfectly connected to the volatility of the fundamentals.”
In essence, even when economic uncertainty grows similarly across countries, currencies do not move in a perfectly consistent manner. It is a “second-order disconnect”: not between values, but between their fluctuations.
The model that reveals the two forces
To explain this paradox, Croce and colleagues have devised a macro-financial model in which two identical countries face two types of global shocks:
- News about future economic growth—which prompts countries to reallocate resources, generating opposite movements in consumption and exchange rate volatility.
- Pure uncertainty shocks — sudden changes in the degree of perceived risk, which move volatility in the same direction.
As the authors write, “When news about future growth rates arrives, the international reallocation of resources generates opposite movements in variances. Instead, shocks to production volatility produce positive co-movements.” The two forces act together, but in opposite directions. The result is an intermediate equilibrium: exchange rate and consumption volatilities are correlated, but only partially. Hence the term “volatility (dis)connect”.
A new way of interpreting global volatility
The key to this work lies in how volatility is reinterpreted: not as noise, but as information. Exchange rate and consumption variability reveal how well countries are able to share risk and absorb global shocks. In developed markets, moderate correlation indicates good but incomplete integration. In emerging markets, the connection is even weaker: uncertainty remains more “local.”
Investigating the impact of trade frictions, portfolio diversification, and market incompleteness offers promising avenues to deepen insights into the global dynamics of volatility.
For investors and policymakers, the lesson is clear: understanding volatility is not just about predicting the next crisis, but about understanding how global risk really is. As Massimiliano Croce explains, “Investigating the impact of trade frictions, portfolio diversification, and market incompleteness offers promising avenues to deepen insights into the global dynamics of volatility.”
A step forward in international macrofinance
The contribution of Croce and his colleagues is twofold. On the one hand, it extends the classic “disconnect” puzzle to movements of uncertainty. On the other, it proposes a theoretical framework that can help interpret phenomena such as the increase in volatility after the pandemic or the contagion effect of trade wars.
In today's hyperconnected world, volatility is not just a measure of risk: it is the language through which the global economy communicates its uncertainty.
R. Colacito, M. M. Croce, Y. Liu, I. Shaliastovich, “Volatility (Dis)Connect in International Markets”, Management Science, 2025. DOI: 10.1287/mnsc.2023.03930
