VIX surges 44% for a three day gain of 62%, closing at the highest levels since the election.
While the market was overdue for a correction after one of the longest sustained periods of record low volatility, Trumps “Fire and Fury” rhetoric is having the effect of someone shouting fire in a crowded theatre that has everyone rushing to the exits at once.
The risks of such record low volatility have been widely discussed for some time in almost every financial publication and our prior posts. Short vol has indeed been a winning trade for the past few years, but reversals can be unpredictable, fast and furious.
Before we point too many fingers at Trump (we’ll get to that), investors have been looking for a reason the sell for quite some time. Howard Mark’s recent memo, sparked a lot of discussion about a market top as did comments by Jeffery Gundlach who recently announced a large short bet on the S&P 500.
The irony here is that only a few short days after taking credit for the record high of the Dow Jones when it broke 22,000, Trump managed to spark a sell-off with his “Fire and Fury” language. While this type of cognitive dissonance may be par for the course for our President, up until now, the markets have ignored it with the hope that either A) his pro-business stimulus will get through or B) nothing will get done and business will go on as usual (and that has been good for the economy).
The danger at this point is that a normal correction could turn into something much worse should the financial markets price in a confrontation with North Korea as being much more likely. It is this type of geopolitical risk that has been in the background for some time now and given the wildcard nature of Trump, the uncertainty of this scenario is much greater and potentially much more severe.
The big risk is that like a cornered rat, Trump may decide that a war with North Korea is a better option than being impeached over the Russia investigation. Between the Senate sanctions on Russia and the escalation of the Mueller investigation into Russia, Trump is feeling the heat and has few places to turn. He would not be the first President who improved his popularity by declaring war on an enemy threatening the US with WMD.
To make matters worse, Kim Yong is perhaps an even bigger wildcard. If we have a difficult time understanding Trump’s intentions, how is Kim Yong in a position to do any better? The options are not good. If he thinks Trump is bluffing and launches another missile close to Guam, Trump may feel justified in a preemptive attack. If he believes Trump is serious, Kim may feel he has little choice but to attack South Korea and Japan. Diplomacy would seem to be in order at a time like this but there are very few statesman in the Trump administration who are empowered to do anything.
We appear to be getting dragged into a crisis by a President who desperately needs attention and wants credit for having done something that reenforces his image of strength. Instigating a conflict with North Korea, by taking the bait Kim Jong Un continues to provide, seems to be the current agenda. We can only hope it doesn’t go any further.
Fortunately, Red Swan Risk has perfected the tools, consultancy, and best practices that prepare our clients for the unknown.
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