‘Playing With Fire’ – Full Week Ahead Preview

Ok, well if you didn’t get enough “fire and fury” during the work week, there was plenty to be had on Saturday in Charlottesville where a large contingent of exceedingly irritated white nationalists turned a peaceful college town into Bakaara Market for a day.

One daily in Charlottesville ran this cover story:

So if you were looking for a reason to think the risk-off mood that prevailed in the wake of Trump’s bombastic rhetoric on North Korea and subsequent threat to invade Venezuela might spill over into Monday, “deadly weekend Nazi rally” should suffice.

It’s not 100% clear to me that central banks, even with the printing presses running full bore, can offset what has become an absurdly precarious geopolitical/policy backdrop. Between the domestic situation in the U.S. (which includes the upcoming debt ceiling debate), North Korea, and Venezuela, this is quickly careening into something that approximates outright insanity.

And all of this ahead of Jackson Hole and a September which was supposed to mark a decisive turn towards balance sheet normalization for both the Fed and the ECB. Not to put too fine a point on it, but Yellen and Draghi may well have to postpone that effort to avoid throwing gasoline on a “furious” geopolitical “fire.”

We’ll get minutes from the Fed, the ECB, and the RBA this week and you shouldn’t think those will be non-events. Here’s BofAML:

For the Fed, focus is on the inflation outlook and discussion of transitory vs persistent factors. Our US economists think the minutes will show general agreement about the roadmap for balance sheet normalization. Furthermore, a discussion over the neutral rate could be on the table, given the recent Fed talk. We also have the ECB minutes where our EU economists think focus is on FX and QE after Dec-17. The opening statement by the ECB’s chief economist is likely to insist and possibly quantify on the impact of the stronger euro on the inflation outlook. We also see the potential for remarks on the recent tightening in wider monetary conditions.

You’re reminded that FX markets are listening very closely for any sign of policy divergence between these central banks. If there is anything – and I do mean anything – in those minutes that’s worth trading on, you can bet someone (or some robot) will fucking find it. Just look at what the aussie did after the last RBA minutes were released – here’s a reminder:

That triggered a mad scramble by RBA policymakers to assure the market that the interpretation was wrong and ultimately, aussie strength has been in focus ever since. Perversely then, the minutes ended up being the subject of the next policy meeting, a hilarious example of the tail wagging the dog.

So there’s that.

There’s retail sales galore this week in terms of econ, including data from China and the U.S. Here’s the China docket for today (i.e. Monday):

• 10am: (CH) July Retail Sales YoY, est. 10.8%, prior 11.0%
• 10am: (CH) July Retail Sales YTD YoY, est. 10.5%, prior 10.4%
• 10am: (CH) July Fixed Assets Ex Rural YTD YoY, est. 8.6%, prior 8.6%
• 10am: (CH) July Industrial Production YoY, est. 7.1%, prior 7.6%
• 10am: (CH) July Industrial Production YTD YoY, est. 6.9%, prior 6.9%

Those will be watched closely following the disappointing July trade data – remember, the market was in a forgiving mood in terms of the yuan after exports and imports missed as traders preferred to focus on the surplus. And indeed the yuan will be in focus “bigly” after hitting a 12-month high against the dollar last week only to fall the most since January on a weaker-than-expected Friday fix.

You’ll want to watch South Korea closely for obvious reasons. We just got this headline from 38 North:

• Recent satellite imagery suggests North Korea may be preparing for a new series of “at sea” test missile launches

Of particular note will be CNYKRW, a pair that’s become something of a barometer for Asia risk. Here’s a bit of color from Barclays:

Geopolitical risk has increased as the US and North Korea escalated their rhetoric. The war of words increased its intensity after reports that North Korea has allegedly acquired the ability to miniaturize nuclear weapons. The saber rattling is most likely an attempt by both sides to establish strong positions before conclusively reaching a stage of mutual deterrence that could lead to concessions later on. In deterrence equilibrium, credible threats and the possibility of large damage from both sides prevents any direct hostile action. A unilateral surprise strike is unlikely to destroy the nuclear abilities of the other country (eg, most of North Korea’s arsenal is suspected to be underground and in unknown locations), giving the ability to retaliate and cause large damage, thus preventing the unilateral attack in the first place and opening the door for peaceful coexistence.

Deterrence counts on the rationality of the opponents. The risks of miscalculations or mistakes are high if governments are not experienced and diplomatic and communication channels, which could help to avoid misunderstandings in the field, are shut down.The build-up of mutual threats and the shows of force in the past weeks have unsettled markets, with risk assets and high-beta currencies underperforming, and it is likely to continue.We continue to recommend JPYKRW as a hedge against increasing risk aversion. Nevertheless, in the tail event of actual conflict, other safe havens are likely to outperform JPY, given the negative regional implications.

We revisit the analysis we had undertaken on April 16, 2017, but with a particular focus on the tensions in the Korean peninsula. We use the Korea GPR index because it is more likely to capture geopolitical risks directly related to North Korea and its regional implications, rather than the global GPR.

Gold and traditional European safe havens outperform in effective terms when there is a spike in Korea’s geopolitical risk, while high-beta and Asian currencies underperform. However, the JPY and KRW show little correlation to Korea’s GPR (Figure 1). Nevertheless, JPYKRW outperforms when global threats, and not actions or Korea-specific risks, are considered.

Another tail risk becomes active this week with the start of the first round of NAFTA renegotiations on Wednesday. The objective of the US of reducing trade deficits, specially with Mexico, might be incompatible with the reality of trade, continental supply chains and NAFTA. The presence of a dispute resolution mechanism and the preservation of Chapter 19 are a must for Canada, and will be a contentious issue during negotiations. Although the institutional channel is being followed and our baseline case is for a successful renegotiation, there are risks around the process. US trade enforcement can be a tool to score political points, given the lack of progress in the legislative agenda, and headline risk for CAD and MXN is elevated.

And when it comes to trade, don’t forget that the Trump administration is said to be readying a crackdown on China in retaliation for Beijing’s perceived unwillingness to “cooperate” on the Pyongyang issue.

Needless to say, all eyes will be on the VIX this week as warnings about the potential for inverse and levered products to panic-buy VIX futs into a vol. spike grow louder every day.

Don’t get too comfortable, because as Barclays reminds you, we’re all “playing with fire” at this point…

Here’s a full calendar from BofAML: