Geopolitical risks are in the driving seat once again

Demand for safe havens returned on Monday, as a new war of words between North Korea and the U.S. triggered a flight to safety amongst investors.

The latest comments came from North Korea’s foreign minister, Ri Yong-Ho, who accused the U.S. of ‘declaring war’ and said that they have ‘every right to take countermeasures’, including the right to shoot down U.S. strategic bombers, even when they are not inside the airspace border of their country. His comments sent gold above $1,310, while U.S. 10-year treasury yields declined four basis points.

In currency markets, the classic safe havens, JPY and CHF, made sharp gains against their major counterparts, while equities in Asia followed Wall Street lower early on Tuesday.

So far, every aggressive selloff in equities and move to safe havens on geopolitical risks, has proven to be shortlived. The best-case scenario is for the U.S. to add more pressure on China and Russia, to increase sanctions against Pyongyang and pressure Kim Jong-un to sit around a negotiation table.

However, as an investor, you should keep all options on the table.

An exciting development was seen in options market, where the trading volume in CBOE’s Volatility Index “VIX” surged on Monday to a new high. The price action was not significant, as the index peaked at 11.21, only to drop back 9% four hours later. This activity may be an early sign of anxiety among investors, who started to consider hedging their positions against a market correction. However, I suggest that you do not jump to conclusions from a single day of increased activity, as it may have been a speculative move.

If trading volumes remain high in the next couple of days, then markets are seriously expecting a considerable correction in equity markets.

Tensions between the U.S. and North Korea were not the only reason for the drop in U.S. treasury yields. The Federal Reserve’s well-known dove Charles Evans, sounded less hawkish in his remarks in to the Economic Club of Grand Rapids.

He said the Fed should wait until there are clear signs that American paychecks and prices are rising, before raising rates again.

So far, there are no signs that inflation or wages will pick up in the next couple of months. The comments made by Evans may be overshadowed by speeches from Neel Kashkari and Janet Yellen later on Tuesday, which will most likely have a stronger impact on the shape of the yield curve.

Oil prices were also making headlines, as Brent hit its highest levels in over two years on Monday, closing above $59.

Tighter supplies and growing demand contributed heavily to the recent 33% surge from July lows. However, the 3.8% move on Monday was driven by threats from Turkey to cut crude flows from the Kurdistan region, as they seek their independence from Iraq.

The Kurdistan region of Iraq currently produces around 650,000 barrels per day, of which 85% goes through the Turkish pipelines.

If the Turks decided to cut crude flows, it would create a shock which markets are currently pricing in. However, I think this is going to be only a temporary threat, given that independence will not happen overnight and OPEC members will quickly cover the shortage. In my opinion, the spread between Brent and WTI has gone too far and should shrink back towards $4-5.