‘Things Have Changed Dramatically’: Please Explain Why Markets Don’t Care About Nuclear War

I’m going to go out on a limb here and suggest that some folks might be underestimating the risk of a geopolitical catastrophe on the Korean peninsula.

I’m basing that assessment on a couple of observations.

For one thing, the KOSPI keeps making new all-time highs:


And then there’s the won, which is sitting near a 1-month high and has had a pretty good year:


Oh, and don’t forget about flows, which have been “robust”:



“Foreign inflow to KOSPI almost doubled [last week] from the previous week to W0.8trn,” Goldman notes, adding that “foreign net buying of bonds strengthened to KRW3.3trn, the largest weekly amount since June 2015.”

As far as USDKRW goes, BofAML thinks maybe market participants are making a mistake. To wit:

The fact that 3-month USD/KRW implied vol is at just 8.3, near the lowest level in two years, suggests that the market is not pricing the risk of US and China playing a Game of Chicken in the coming months.

The market may think that it has history on its side (Chart 3), but the fact that North Korea has demonstrated that it now has the ability to strike the US and that Kim Jong-un appears to be a less rational player than his father and grandfather would suggest that the game may have changed dramatically. We would caution against placing too much faith in history.


That is hilariously blunt as far as sellside research goes.

And that brings us to the second part of BofAML’s “Games Of Chicken” note (you can read the first installment here).

Read below as the bank maps out a game-theoretic approach to the standoff between Donald Trump and North Korea, and do recall that the point of BofAML’s analysis is that cross-asset volatility seems to suggest that investors are woefully mispricing geopolitical/policy risk…

Via BofAML

2017 has seen a serious escalation of tension on the Korean Peninsula:

  • The North Koreans have launched 11 missiles since Trump’s inauguration.
  • On the 4th of July, North Korea marked a milestone by launching successfully its first ever Intercontinental ballistic missile that some experts have said could reach Alaska
  • Rex Tillerson, the US Secretary of State, said after the ICBM launch: “Testing an ICBM represents a new escalation of the treat to the United States, our allies and partners, the region and the world.”

The approach of the new administration in Washington until now has been to pressure China to bring North Korea under control. After the meeting between President Trump and President Xi at Mar-a-Largo in April, Trump tweeted that “Why would I call China a currency manipulator when they are working with us on the North Korea problem,” implying that a deal had been made.

Lately, Washington has made it increasingly clear that it is not happy with China’s progress to date. H.R. McMaster, the US National Security Adviser, said at a news conference recently that “I don’t think China is doing enough now because the problem is not resolved.” The pick-up in Chinese imports from North Korea in May has reinforced the change in tone from the White House (Chart 2). Even before the latest ICBM launch, the Treasury department announced a series of sanctions against Chinese entities (including Bank of Dandong) that it accuses of aiding North Korean’s nuclear program.


It seems reasonable to assume that unless China begins to take more concrete actions against North Korea, the US will have no choice but to increase pressure on China. We see this situation as very similar to the tax reform showdown discussed earlier. Indeed, we think the hypothetical game we came up with to describe the latter is equally relevant for understanding the US-China conflict.


The same game as tax reform! In Exhibit 2 we have adapted the tax reform game by simply changing the names of the players and the actions available to them, leaving the pay-offs unchanged:

  • There are good reasons to think that the US would be indifferent between Scenario 1 and Scenario 2. Labeling China as a currency manipulator could spark a trade war between the US and China (bad) but not doing anything could cost the US the only non-military option it has for dealing with the North Korea problem (also bad).
  • We don’t think our assumption that China is better off in Scenario 2 than Scenario 3 is unrealistic. This is because if China exerts real pressure on North Korea (Scenario 3) it could unleash unforeseen consequences such as implosion of the Pyongyang regime and unification of the Korean peninsula.

What this means is that like the tax reform game, the only Nash equilibrium involves both players playing mixed strategies. As we know from the tax reform game, this implies a high degree of uncertainty in terms of the outcome of the game. 

Yes, “a high degree of uncertainty in terms of the outcome,” which isn’t consistent with the way markets are acting in terms of Korean assets and certainly isn’t compatible with this:


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