Trump is flirting with financial chaos
Paul J Davies
US President Donald Trump’s sudden turn to declare near-victory in the war against Iran suggests he has at least one eye on the blowback from the global tariff debacle of almost a year ago. A shocking and ill-considered action? Control. Disruption of trade? Control. Inflationary consequences? Control. A sharp increase in financial volatility and widespread market disruption? Control. The main difference is that it is much easier to back out of a trade war than to back out of an actual trade war.
Last April, when Trump’s overly aggressive global tariffs triggered a meltdown in stocks and bonds, Treasury Secretary Scott Bessent and business leaders including JPMorgan Chase & Co chief executive Jamie Dimon intervened to persuade the president to repeal most of those tariffs within days. It won’t be nearly as easy to save the United States from a Middle East war with unclear aims against a complex and stubborn rival. Aside from the lives at stake and the potential for broader economic distress, the rapid spread of chaos to markets is another reason why Trump’s adventurism appears misguided.
Last year’s tipping point was the sharp sell-off in US Treasuries; 10-year yields jumped from 4 percent to 4.5 percent. This week, a rise in oil prices to almost US$120 ($169) per barrel on Sunday sparked fears about the inflationary effects of prolonging the war. In both cases, aftershocks quickly spread to other markets. Volatility measures in stocks, bonds and currencies rose late last week, making investors nervous. However, other markets also calmed down as oil prices fell to around $90 on Tuesday. Investors were already hoping to see a quick resolution before Trump signaled his desire to resign in remarks Monday evening. But markets are not out of control yet.
“A lot of asset classes are now almost tick-tock following oil, so that’s what’s paramount for markets right now,” said Deutsche Bank strategist Jim Reid. “All headlines should be interpreted in light of what they will do for the price of oil.”
The structure of modern finance can quickly turn dramas into crises, and the moves following last year’s global tariff announcement were the latest example of this. The widespread use of borrowed money and derivatives means that sudden changes in sentiment can trigger self-perpetuating spirals as investors react to measures of how much they risk losing value.
For many large investors, larger price increases or declines in any asset feed directly into their patterns, which tells them to trade in the direction the market is currently moving. They sell when prices fall and vice versa. This common approach to risk management across various types of systematically managed funds is one reason why problems in one market can quickly manifest in others.
The proprietary trading arms of the large multi-strategy firms and electronic market makers that dominate the hedge fund world can be a direct source of contagion between markets when losses in one area prompt them to reduce risks in another. The more borrowed money these funds use to increase their bets, the more susceptible they become to rising volatility and value-at-risk patterns. This is why sudden changes in direction have such a big impact. Three major firms (Balyasny Asset Management, Millennium Management and Point72 Asset Management) suffered losses last week, according to Bloomberg News.
While in recent years such funds have become the most important traders in the US and UK government bond markets, they also play an important role in many other markets. Public debt prices are the cornerstone of finance; Therefore, when multi-strategy hedge funds sneeze, every investor runs the risk of catching a cold.
Regular mom-and-pop investors are also using more leverage these days through other leveraged products like options betting and some exchange-traded funds, which are becoming popular on platforms like Robinhood Markets. They, too, can contribute to the turmoil through their trading and hedging by dealers who service this activity.
Sometimes volatility storms can appear almost out of nowhere. U.S. stock markets experienced a brief wild rally in early August 2024 after a prolonged period of volatility was quelled by steady systematic flows into similar investment strategies. An unexpected interest rate hike in Japan and somewhat disappointing U.S. earnings were all it took to lead to a sharp increase in volatility and a 6 percent drop in the S&P 500 in three days. This reversed almost as quickly once enough sensitive bets were settled.
But things often get more troublesome when government bond markets cause a boom or are absorbed by troubles elsewhere. The threat that trading in Treasuries was about to become dysfunctional helped nudge the White House’s tariffs in April. The takeover of Britain’s gilt market was a key factor in the sacking of former prime minister Liz Truss in late 2022.
With oil prices falling below $100 per barrel, the main indicators of fear in the markets seem to have calmed down. But the VIX volatility index on the S&P 500 is at its highest level in weeks after Trump’s global tax day.
The same volatility and leverage dynamics can reverse, helping markets recover as quickly as they stumbled. A new rise in oil prices risks sparking a new conflagration, and the intractability of a complex war with Iran means it will be much harder to extinguish.
Bloomberg
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