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What Do Bond Markets think of the Nuclear Button?

Since the division of Korea at the end of World War 2 in 1945, the two countries occupying the North and South sides of the Korean peninsula diverged on to two completely different economic paths. Whilst South Korea has experienced one of the largest economic transformations over the past 60 years, becoming the 4th largest economy in Asia and 11th in the world in terms of gross domestic product (GDP), North Korea has morphed into a hermit kingdom under communist leader Kim-Jong Un and his predecessors, whose nuclear ambitions have led to the placement of restrictive economic sanctions by the United States and much of the Western World that has stifled the country’s economic growth.

Despite this stark disparity between the two rivals, their respective capital cities of Pyongyang and Seoul lie only 190 kilometers apart, with Seoul located a mere 55 kilometers from the demilitarized zone that divides the two countries. With an estimated 13,000 artillery pieces positioned along the border, it would be reasonable to assume that a rationale investor would deem that holding a 10-year South Korean government security would require a much higher rate of return in the form of yield than that of a similar security from a nation whose capital city lies roughly 11,000 kilometers from North Korea. However, as we observe this does not appear to be the case at all (Figure 1).

Figure 1: 10 Year Treasury Bonds for South Korea, USA & Australia

Source: BondAdviser, Bloomberg

Instead, we see the gradual convergence of 10-year sovereign bonds from South Korea, the United States of America and Australia over the past five years, with movements in yields showing a remarkably strong correlation with one another. With 10-year treasury yields often seen as a proxy for long-term growth and inflationary expectations the market may simply not deem the recent tensions and peace prospects during the Trump administration as genuine threats or salves. If one looks at short-term sovereign debt yields instead (Figure 2), one is able to gain an enhanced insight into investors reactions to both inflammatory and amicable comments made by President Trump and Kim-Jong Un alike.

Figure 2: 3 Year Treasury Bond Index for South Korea, USA & Australia

Source: BondAdviser, Bloomberg

The US yield curve has increased quite steeply since the beginning of 2018 whilst both the South Korean and Australian curves have stayed reasonably flat as the federal reserve has lifted interest rates twice this year, with more interest rate hikes probably on the way. However, this incline was interrupted with a significant decrease on the 24th of May as President Trump called off the scheduled meeting with the North Korean dictator in Singapore, citing open hostility displayed by the North Korean government officials who had threatened to strike the US with their nuclear arsenal that sent world tensions high and investors fleeing towards safe haven securities such as sovereign debt. US yields decreased by 10 bps (0.1%) in the span of a week. Contrarily, on the 1st of June, with the US president declaring that the North Korean summit would indeed go ahead, a drastic reversal occurred with the 3-year treasury yield spiking by 9bps (0.09%) to again reach levels previously seen before the meeting was originally called off.

This poses the question as to why we are only observing this trend in US sovereign debt yields and not for South Korean equivalents despite previously observed correlations. Furthermore, why was there no meaningful movements in South Korean sovereign bonds when South Korean President Moon Jae-In engaged with Kim-Jong Un in peace talks in late April, the third meeting between Korean leaders and the first time a North Korean leader has stepped foot in the South since 1953. Such observations could be boiled down to simply apathy by investors who do not believe any meaningful outcomes will be derived from such meetings. They may instead pay more attention to President Trump’s twitter tirades, or, much more likely, they are paying due respect to fundamental economic data and company profits arising from the world’s largest economy. Regardless, it will be very interesting to see how the world’s current geopolitical dramas continue to unfold and what, if any ramifications this has on sovereign debt yields globally, and not just those a stone’s throw away from North Korea.