David Woo (still) has chickens on the brain.
These chickens have been pecking at Mr. Woo for months. If you’ve missed the “chicken dance” discussion, you can start here and work your way back.
Basically, there are two games of chicken at play on the (geo)political stage:
- Trump vs. pretty much everyone on tax reform (competing agendas and the fractious character of the Republican party effectively means no one is on the same page, creating a scenario where there are effectively more than two political parties vying to advance their interests)
- U.S. versus North Korea
Woo’s contention has long been that markets aren’t pricing the risks associated with these “games” appropriately and his latest note (called “Chickens Wanted”) builds on that notion.
As far as tax reform is concerned, David contends that “the fact Trump pushed to raise the debt ceiling and keep the government funded only until December 15 reinforces our long-held view that the only real lever Trump has over Congress regarding tax reform is his ability to shut down the government.”
For our part, we remain skeptical about the prospects for tax reform despite last week’s half-hearted effort on the part of the GOP to reassure the market that something (anything) is coming on September 25. That said, what we saw in the dollar and yields certainly seems to suggest that “something” would be infinitely better than “nothing”.
Woo believes that tax reform is more likely to get done now that Trump has demonstrated a willingness to reach across the aisle (although that “reach” was so desperate and unconditional that it makes one wonder whether Trump has reverted to being a Democrat). To wit:
The failure of healthcare reform was a lesson about the risk of putting all the eggs in one basket. By siding with the Democrats, Trump shows he is open to a bipartisan approach to doing tax reform. An alliance between Trump and the Democrats makes sense at many different levels. To begin with, there is probably more common ground between Trump and the Democrats on fiscal policy (e.g., more infrastructure spending; lower income tax for the middle-class; higher income tax for the rich) than between Trump and his own party. Moreover, by reaching out to the Democrats, Trump may be trying to pressure the Republicans to move more decisively on their own tax reform proposal. The fact that Treasuries sold off and the USD rallied last week would suggest that the market agrees that a bipartisan approach could breathe new life into tax form.
Still, BofAML notes that this is “a very high stakes game of chicken with many things that can go wrong between now and December.” Things like these:
The upcoming budget process could seriously undo the rapprochement between Trump and the Democrats; House Republicans and Senate Republicans may not be able to reach agreement on tax rates; the White House and House Republicans may not be able to agree on the tax treatment of interest expenses; the Tea Party may try to block any deal that would significantly boost the deficit. In our view, political brinksmanship may be the only way left to do tax reform and the process will be neither smooth nor pretty. Moreover, as time passes, we think tax reform is becoming increasingly binary. If it cannot get done by year-end, the odds go up that it will never get done as next year is an election year and political appetite for doing tax reform will shrink.
So what does an exceptionally contentious atmosphere around an increasingly binary outcome mean in the current market context? Well, it might mean that rates vol. is too cheap:
Ok, so what about the other game of chicken? As noted earlier this morning, markets don’t seem to be too concerned about North Korea’s latest provocation. Indeed, the Kospi just had its best day since May:
And that, coming off a week in which South Korean shares rallied nearly 2% even as Kim fired another missile over Japan. Here’s Woo again:
Concerns about geopolitical risks are growing. Our latest FX and Rates Sentiment Survey (September 8) shows that investors perceive geopolitical risks as the most likely trigger of higher market volatility for the rest of 2017 (Chart 7).
Equally clear is the fact that investors do not appear to be in a hurry to act on these concerns. Implied volatility and risk premium across markets remain near their year-low. Even those markets that are most directly linked to geopolitical risks shows few signs of panic. The South Korean stock market, which has rallied 18% YTD, is just 2.6% off its year-high. The KRW has risen 6% against the USD so far this year (Chart 8), keeping pace with its Asian counterparts like the SGD and TWD.
So you know, “what could go wrong”?
As it turns out, quite a lot.
Because as BofAML goes on to remind you, “sanctions are not working” on “Rocket Man” and the reason for that is the same as it ever was: namely that the only way for Kim to maintain his iron grip on power is to perpetuate the myth that Pyongyang is locked in an eternal struggle with Washington. That is of course absurd, but it serves as the basis for the familial reign in the North and it’s the story the country’s citizens are force-fed from birth. Trump’s antics effectively make that myth a reality – or at least more real than it would have been otherwise. Here’s BofAML again:
Why are sanctions not registering the intended reaction? Is it possible that the North Korean leadership has invested so much political capital into the brinksmanship with the United States that accepting a defeat could seriously weaken its ability to rule or remain in power? Turning back may no longer be an option. Given the likely crippling economic impact of the new sanctions (designed to reduce North Korean export by 90% and energy import by 30%), game theory suggests that the North Korean leadership has a strong incentive to bring forward the final phase of the Game of Chicken.
Despite that, markets don’t seem to care because as Woo goes on to write, “incredibly, USDKRW vol curve remains not only upward sloping (Chart 10) but steep, with 6m implied vol trading at an average premium over 1m (Chart 11) [clearly demonstrating] the market is not priced for any short-term shock.”
So what to do? For the enterprising among you, you might try hoarding short-dated KRW puts or, as Woo suggests, buying KRW gamma against selling long-dated vol.” (i.e. positioning for a curve inversion in the event this spirals out of control).
But who knows, right?
After all, “bad news is good news” when it comes to forcing DM central banks to hold off on policy normalization and tapering. Or, in other words, “all’s well that ends in a nuclear war on the Korean peninsula and a government shutdown in D.C.”