US intelligence concluded that North Korea has recently developed the capability to produce a nuclear warhead that would fit on to the intercontinental ballistic missile that it has been developing. This coupled with claims that North Korea was moving to make active defensive weapon systems, spurred an escalation of rhetoric between the US and North Korea. President Trump threatened North Korea with a " fire and fury" as the "world has never seen." While North Korea reportedly responded by revealing that it was considering a preemptive strike against US forces in Guam.
Washington contacts suggest that North Korea is still missing two key pieces of technology. One has to do with the integrity of the nose one that needs to withstand intense force and heat as it re-enters the atmosphere. The other is a guidance system. The latter seems to be of lesser importance.
North Korea would have a counter-value (urban centers) targeting strategy rather than counter-force (military targets, like missile silos). Counter-value strategies for obvious reasons do not have to be as accurate as counter-force strategies. In any event, North Korea apparently is progressing faster than previously anticipated, according to the latest thinking, and could be ready in a year's time.
The US has threatened to use force to deter North Korea, but it prefers to use multinational efforts and sanctions. Despite the rhetoric of unilateralism, the Trump Administration is attempting to find an alternative to a US-North Korea confrontation. China has taken modest steps, but it has no desire for unrest on its borders, and it fears that a united peninsula would be dominated by South Korean interests, which means the US.
Japan, with whom the US has a security treaty, has been threatened by North Korean missiles for many years. Prime Minister Abe has been pushing for a stronger Japanese military, and through a recent reinterpretation, its defense forces can be used to defend allies. A united Korea would be a significant economic rival. For its part, South Korea's new government appears willing to accept the fait accompli and continue to seek a negotiated settlement.
There have been many op-ed pieces comparing the current situation with the Cuban Missile Crisis. This tends to be cited by those who sense the Rubicon is imminent and want decisive action now. On the other hand, the experience with Iran may be more apropos. It is a marathon, not a sprint. There is the creation of an incentive structure that was ultimately persuasive for Iran.
There is also a good reason why time is on America's side. Its missile defense system continues to become more sophisticated. Remember the US spends roughly as much on defense as the rest of the world combined. South Korea has begun installing a US missile defense system, and it has antagonized China, which sees it as a forward projection of US power to its border.
The markets have barely responded to the escalation of rhetoric. The US dollar enjoyed a firm tone, but we would suggest that the move began last week and that the in our assessment both technical and fundamental considerations favored a stronger dollar before these latest developments. Gold enjoyed a large outside up day on Tuesday by trading on both sides of Monday's range and closing above Monday's high. This is a constructive technical sign, but in the spot market, gold stopped at $1265.50, the 61.85 retracement of its losses since the start of the month. US T-bill yields were little changed (one-month bill yield move on Tuesday was about a quarter of a basis point). The US 10-year yield is also essentially unchanged since the end of last week.
The Dow Jones Industrials snapped a 10-day rally with a minor loss (-0.15%), while the S&P loss of 0.25% looked more ominous, with a potential key reversal. The S&P 500 made a new record high (~2491) before selling off through Monday's low (~2476) and closing below there. The S&P 500 has been up every month this year but March. Worries about Korea did not seem paramount to the accounts of Tuesday's price action. Given the failure of the US market to hold on to early gains may also weigh on Asian shares on Wednesday.
The yen is interesting. It is the only major currency to have gained against the US dollar over the past five sessions. These gains have come over the last several hours. We argue that the safe haven appearance of the yen is largely a function of the behavior of Japanese investors and short-covering rather than the yen and Japanese markets that investors are putting their savings for security. We suspect that the unwinding of long euro and short yen positions weighed on the dollar against the yen. A break of JPY109.85 could see the dollar fall toward JPY109 rather quickly. This, in turn, could lift the yen on the crosses, and push the likes of the euro, sterling, and Australian dollar lower.