Beware the fat tails

US equity markets found little direction in Monday’s session as investors waited for news about US-China trade talks now underway in Beijing. This week’s vice-ministerial talks are supposed to prepare ministerial talks, which in turn are supposed to prepare a Trump-Xi summit at some point in March.

Risk as gauged by the implied volatility of index options in major equity markets continues to drift downwards. This reflects the consensus belief that China will offer up enough concessions for President Trump to declare victory and go home, as the late Senator George Aiken advised the United States to do at the height of the Vietnam War.

China will open its market to selective industries, buy anything the US cares to sell including lots of LNG and agree to protect US IP and know-how. Trump will postpone the threatened tariff hike on Chinese goods to 25% from 10% and eventually rescind the 10% tariffs.

That’s what is supposed to happen, but investors are buying insurance against the eventuality that everything goes horribly wrong.

Even though volatility – the market’s standard risk measurement – continues to fall, the price hedges against extreme outcomes are rising. Gold and US inflation-protected Treasuries are a form of long-term disaster insurance: In a financial crisis, the Fed will add liquidity with abandon, flooding the market with dollars and depreciating its value.United States

Gold is a preferred hedge against such an eventuality, remote as it might be. So are Treasury Inflation-Protected Securities (TIPS), which are indexed to inflation.

As the Fed backed away from its plans to raise interest rates – and called into question its plans to reduce its $4 trillion balance sheet – federal funds futures rose and the gold price jumped. TIPS yields fell – that is, TIPS became more valuable – and the gold price rose. That is remarkable in the context of a benign inflation environment.

Ten-year inflation expectations built into the bond market – the difference between the yield on ordinary 10-year Treasuries and 10-year TIPS – predict an inflation rate of 1.8%, below the Fed’s 2% target. A chill deflationary wind blew through markets at the end of December, persuading the Fed that the risk of inflation was small next to the risk of a market crash.

What could go wrong? Pretty much everything that President Trump has advanced by the way of economic diplomacy has hit a brick wall. US officials are fulminating against Huawei, the world leader in 5G technology, but don’t have an alternative to offer.

Germany’s Economics Minister Peter Altmeier told Die Welt last Sunday that Germany “will not be blackmailed,” referring both to prospective Russian pressure through natural gas supplies over the Nordstream II pipeline and to American efforts to persuade Germany not to work with Chinese telecom providers. “We will not compromise on our safety,” said Altmeier.

“But it is also clear that we are starting the 5G network expansion as soon as possible – also in order to secure Europe a competitive position on the world markets.” The phrase “as soon as possible” means “work with Huawei,” the only provider of 5G technology that can hit the ground running.

By contrast, reported the US website Politico, Trump’s “message to Europe about 5G … has been “go slow. There’s no need to rush into this. We need to figure out how to do this now.”

Former Australian Prime Minister Kevin Rudd summed up the situation in a February 11 interview with CNBC. The probability is high that some sort of interim deal will be announced before March 1 “because both sides have the political will” to pursue a deal, but this will not resolve “the unfolding economic war between the US and China. Rudd added: “If you’re an investor you should be mindful of the unbalanced strategic direction of US-China relations.”