On Monday morning, we excerpted from the latest report by BofA's David Woo, who echoed a familiar lament when looking at the divergence between global political risk and the collapse in cross-asset volatility, concluding that he finds it "difficult to reconcile the record low volatility in financial markets at the moment with growing political risk in Washington and geopolitical risk in Asia. There are many reasons why we are living in a different world than the one we used to know and we would caution against relying too much on history for forecasting the likely outcome of these risks."
Specifically, Woo calculated that aggregate volatility had tumbled to record lows, and matched levels last seen in 2007 and 2014.
He then said that what these two episodes had in common "was that the Fed was seen as either done with hiking rates or still far away from starting to hike rates" and adds that "this makes it very difficult to reconcile the current depressed level of volatility and the fact that the Fed is still in the middle of its hiking cycle." Adding to his confusion, Woo pointed out two specific and "dangerous" events which the market appears to be deliberately ignoring, potentially with dire consequences as they unfold over the coming weeks: "If the market is underpricing the uncertainty with respect to the outlook of US monetary policy, we are even more concerned that it seems totally impervious to the risk of two potentially disruptive, if not dangerous, Games of Chicken likely to unfold in the summer and the beginning of the fall."
The games he envisions involve the ongoing showdown in Washington on one hand - which after yesterday's collapse of Obamacare repeal is only likely to escalate - and the potentially far more lethal situation involving North Korea.
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Here is Woo's explanation of why he believes the market is underpricing the risk from these two "games of chicken":
Showdown in Washington
In our view, the risk is increasing that a Game of Chicken will be played out in Washington this September, with serious market consequences. What we have in mind is a showdown over tax reform between the President and the Republican controlled Congress:
- The White House has repeatedly said that tax reform is the top priority of the administration. This is likely to be even more the case if the GOP fails to push through healthcare reform. The New York Times reported back in March, citing sources close to the President, that Trump regretted going along with doing healthcare reform before tax reform.
- Meanwhile, tax reform has been delayed again and again. There is no agreement between GOP House leadership and Senate leadership over how to pay for the proposed tax cuts.
- In September, Congress will have to reach an agreement over the fiscal year 2018 budget to avoid a shutdown. Around the same time, Congress will have to raise the debt ceiling to avoid a default by mid-October. A potential shutdown and/or default may be the only levers the President has over tax reform before it becomes too late.
- There are good reasons to think that the President has a strong enough incentive to enter into a Game of Chicken with the GOP. After all, it will be the GOP rather than Trump that will be facing re-election next year. There is a general consensus that without tax reform the GOP could lose their majority in the House.
- Last month Steve Mnuchin, the Secretary of Treasury, said during Congressional testimony that, "At times there could be a good shutdown, at times there may not be a good shutdown. There could be reasons at various times why this is the right outcome." This echoes Trump's tweet back in May: "Our country needs a good shutdown in September to fix mess."
Set-up of the game
To illustrate the above dynamics, we have created the following hypothetical game between Trump and the GOP. The game has possible two stages. In the first stage, the GOP will decide whether to pass tax reform or not. If they do, the game is over. If they do not, in the second stage of the game the President will decide whether to force a shutdown of the government or not.
Exhibit 1 outlines this hypothetical game and the pay-offs for the two players in each of the three potential scenarios:
- The best scenario for the President is Scenario 3 (tax reform and no shutdown). We assume that he is indifferent between Scenario 1 (no tax reform and shutdown) and Scenario 2 (no tax reform and no shutdown). The former scenario would poison his relationship with the GOP while in the latter scenario he would lose credibility.
- The best scenario for the GOP is Scenario 2 (no tax reform and no shutdown). We assume that it trumps Scenario 3 (tax reform and no shutdown) because any tax reform is likely to be controversial and could be politically costly. The worst scenario for the GOP is Scenario 1 (no tax reform and a shutdown).
This game could be seen as a sequential Game of Chicken. It is quite similar to the decision tree faced by the US and the Soviet Union during the Cuban missile crisis.
Whereas the Game of Chicken has two Nash equilibria, our modified Game of Chicken does not have any pure strategy Nash equilibrium at all:
- Given our assumption that Trump is indifferent between Scenario 1 and Scenario 2, the GOP cannot know for sure what the President will do if there is no tax reform (50:50).
- Assuming the GOP is risk neutral, this means that the GOP will be indifferent between passing and not passing tax reform (the expected payoff for both no tax reform and tax reform is the same at -5).
The only Nash equilibrium in this game involves mixed strategies whereby each player randomly selects a pure strategy.
Buy hedges before it is too late
This above game is meant to demonstrate the possibility of escalating tension as well as the high uncertainty around the outcome as we move into September. With volatility at two-decade low, the market has not priced in even a slight probability of this kind of upheaval, in our view.
We continue to like hedging this risk by buying JPY call/USD put (current: 0.29%) and buying a straddle on US 2y-10y spread (current: 8bp in the money) that we recommended a few weeks ago. These trades will benefit from increased volatility and a potential risk-off. The fact that Janet Yellen last week acknowledged "fiscal uncertainty" in her Congressional testimony as one of the two main risks facing the Fed gives us confidence that monetary policy would likely be held hostage by the potential fiscal showdown ahead. This means that increased fiscal risk should be associated with lower US rates and lower USD/JPY.
Notwithstanding our concern that the path to doing tax reform the easy way may be closed, we are still optimistic about tax reform getting done through the hard way. The key lesson to take away from the TARP vote was that a real crisis forces people to do the right thing in the end. In our view, the crisis will bring about tax reform which in turn will be followed by a resumption of the Trump trades (higher rates, higher USD). This is why we like owning rates vol rather than going long rates per se.
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Game of Chicken and North Korea
2017 has seen a serious escalation of tension on the Korean Peninsula "Trades after the ICBM, July 10):
- The North Koreans have launched 11 missiles since Trump's inauguration.
- On the 4tof 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 Pyeongyang 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.
Market over-reliant on history
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.
We find it difficult to reconcile the record low volatility in financial markets at the moment with growing political risk in Washington and geopolitical risk in Asia. There are many reasons why we are living in a different world than the one we used to know and we would caution against relying too much on history for forecasting the likely outcome of these risks.