As a Korean-American and someone who likes to think about game theory, I have some thoughts on the Korean situation. We had the start of a crisis rally last week. It’s always difficult to see how much panic is going to be priced into the market. Putting my thoughts down on paper helps me organize my trade thoughts:
- There is “ZERO” chance that North Korea will launch a missile at the US (Guam) first. You may have noticed that I used three qualifiers. The odds for something like a missile launch can never be truly zero. So let’s call this “a percentage as close to zero as possible without it actually being zero.” The second caveat is that I think it’s possible North Korea could fire a missile “near” a US territory, without it actually hitting anything – sort of like what they did to Japan a few weeks ago. And finally, North Korea will not launch a missile at the US “first”. That would just be suicide. Over our long history, the US has always shown a willingness to go to war over any attack on our territory. There is nothing to be gained from a war with the US. North Korea is not that dumb…
- There are three main reasons North Korea developed nuclear weapons. (1) Self-defense. There have been many a dictator that has been deposed from the lack of having a proper deterrent. Nuclear weapons are that deterrent. (2) Bargaining chip. It’s easier to “beg” for food and supplies when you have a nuke. In the past, South Korea and the world has always been willing to offer peace offerings to hostile North Korean overtures. This has been going on for DECADES, and there is no reason to think the situation has changed. (3) Possible industry? I suppose there many groups that could want a nuclear device. And it’s not as if North Korea couldn’t use the money. A mad dictator going out in a blaze of glory may make for a good claymation movie, but this is NOT one of the plausible reasons for developing nukes.
- There is a “non-zero” risk that the US attacks first. One would have to think that the US military intelligence would have to be extremely certain they can completely defang North Korea before attacking. There are ten million people in Seoul, and even more in the surrounding areas. So you basically need to be 99.99+% sure an effective counterattack couldn’t happen. World opinion (and world courts) will take an extremely negative view of any action that results in large casualties. That seems like an extremely high bar to overcome for the US to launch an attack. I would think the US should defer (and at least consult) the attack decision to the country that has the most potential lives to lose – South Korea. The new South Korean president is a pacifist, so it is extremely unlikely Moon would agree to any kind of first strike.
- Being perceived as crazy in negotiations can be a plus. People always underestimate the power of crazy. It works for Kim – you could probably get more in concessions if you are deemed to be unstable. It could work for Trump – the fact of the matter is, having a perceived “trigger happy” President will prevent enemies from getting out-of-line. So I don’t “hate” how Trump is handling the current situation. You have to strongly communicate that any attack will not be tolerated. Okay, maybe his word choice could have been better. I just see this as tomato-tomahto. I can see how the markets could be rattled. I’m just not sure it is justified – strong language toward an attack is a MUST.
- Most major investors are Trump haters. Trump was elected mostly by middle America. The large financial centers did not vote for him. And my small global sample gives me the impression that an even larger percentage of the world community has a very low opinion of Trump. All other things being equal, the global markets may overreact, because the markets may look at Trump with anti-Trump lenses. During the election, there was widespread fear among Trump haters that Trump should not be allowed anywhere near the “button.” Someone who acts emotionally and impetuously should not be allowed to start a nuclear Armageddon. We may be seeing some of that manifest in the markets.
The issue now is, how far will the market panic go? This is always difficult to judge. We saw some large buying in the reds on Friday. The curve move (reds-gold bull steepening) is also indicative of a crisis move. Clearly some large players in the markets think things get worse. Granted, part of this was the weak CPI, with implications for a weak PCE in a few weeks. We also get a potentially weak Retail Sales next week. The flattener had been the trade of choice among some in the markets, so it’s possible this is just an unwind.
The key for me will be how equities hold up. The chorus of “equities are overvalued” has been getting louder every year, with even the Fed mentioning it more recently. So some equity selloff last week should not be a surprise, all thing considered. Most people with money (especially in financial centers) have little confidence in Trump. I’m not saying confidence is warranted. I’m just saying from a heterogeneous market segmentation perspective, you would expect those with the least confidence to unwind first. We are also approaching that seasonal time where equity market crashes historically happen. This is why we got on some cheap options crisis trades earlier. If equities hold up, I would think rates could recover. If equities don’t hold up, then we could see more of a panic.
What does the Korea crisis mean for fixed income trading?