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North Korea nuclear missile risk causes obscure trade by hedge funds to surge

  • Typical safe-have trends showed little sign of fear Wednesday after North Korea's first intercontinental ballistic missile test.
  • But some hedge funds bought protection against a South Korean default.

A man walks past a TV broadcasting still photographs released by North Korea's state-run television KRT of North Korea's Hwasong-14 missile, a new intercontinental ballistic missile, which they said was successfully tested, at a railway station in Seoul, South Korea, July 4, 2017.
Kim Hong-Ji | Reuters
A man walks past a TV broadcasting still photographs released by North Korea's state-run television KRT of North Korea's Hwasong-14 missile, a new intercontinental ballistic missile, which they said was successfully tested, at a railway station in Seoul, South Korea, July 4, 2017.

Hedge funds bought protection against a South Korean default after North Korea on the July 4 holiday tested a missile some believe could strike the U.S.

"There's definitely elevated risk," said Larry McDonald, author of the Bear Traps Report investment newsletter. "But I'm shocked we're not seeing more carryover to other things."

The cost of protection against South Korea's inability to pay back loans, as measured by the country's 5-year credit default swap, climbed to 57.43. That's its highest since May 19, but still below the year's high of 61.47 on April 19. S&P had an AA credit rating and a stable outlook for South Korea as of August 2016.

South Korea 5-year credit default swap (year-to-date performance)

Source: Reuters

However, safe haven trades in the broader market showed little sign of fear Wednesday. Gold futures for August delivery rose about $2 to trade near $1,221.10 an ounce. Benchmark U.S. Treasury yields traded lower after hitting multi-week highs last week. The CBOE Volatility Index (.VIX), considered the best gauge of fear in the market, traded near 12, its highest since just Thursday.

"The market's become numb to North Korea," McDonald said, adding that trade volume on the credit-default swaps was likely light due to the July 4 holiday. He also noted the last time hedge funds significantly stepped up their purchases of insurance against a South Korean default, that trade didn't work out so well for them.

In April, the cost of the default swap leaped to its highest since July 2016 as North Korea's nuclear threat grew amid a war of words between North Korean state media and President Donald Trump's tweets. But the price subsequently declined as the nuclear threat appeared to wane.

North Korea's first intercontinental ballistic missile test came just ahead of Independence Day celebrations, when U.S. markets were closed following a light half-day trading session Monday.

In response, the U.S. and South Korean soldiers fired "deep strike" precision missiles into South Korean waters Tuesday, according to U.S. military officials in Seoul cited by the Associated Press.

Asian markets closed slightly higher, with the Korea Kospi up 0.33 percent and the Hang Seng up half a percent. European stocks traded mildly higher.

The iShares MSCI South Korea Capped ETF (EWY) briefly fell more than 1 percent.

In morning U.S. trade, stocks traded mixed after markets reopened following the July 4 holiday. Energy stocks led S&P 500 declines and Home Depot had the greatest negative impact on the Dow Jones industrial average.

"I just don't see a military solution. I think the market feels the same way," said Ian Winer, head of equities at Wedbush.

To be sure, he pointed out that North Korea could soon find other reasons to test its missiles. Saturday marks the anniversary of the death of the state's founding dictator, Kim Il Sung.

Trump is scheduled during the G20 meeting this week in Germany to meet the leaders of two major countries neighboring North Korea: Chinese President Xi Jinping and Russian President Vladimir Putin.