Chickens More Likely to Come Home to Roost for Markets: BofA

(Bloomberg) -- The chances of two “games of chicken” that could trigger a market sell-off have risen, according to Bank of America Merrill Lynch strategist David Woo.

The political risks -- a showdown in the U.S. over tax reform, and a confrontation between the U.S. and China over North Korea -- were first identified by BofA two week ago. Strategists said they were yet to be priced in by the market.

Woo says developments since then have increased the probability of one or other taking place, and views the yen as a relative safe haven should this happen.

“In our view, political risks rather than economic risks may provide the catalyst to a general risk-off in September,” Woo, the head of global rates and currencies research, wrote in a note.

Read: GOP Pivots to Tax Cuts Amid Frustration at Lack of Detail

He points to a number of factors that make a clash between President Donald Trump and the Republicans over tax more likely, including:

• The party is divided over an online sales tax and a sharp increase in income tax for the wealthy that could cost votes in the 2018 mid-term elections.
• President Trump's interview with the Wall Street Journal on July 25 made it clear that the administration is considering financing a middle income tax cut by raising levies on the rich.
• The fact that Senate Republicans failed to pass healthcare reform over one vote highlights the challenge of achieving anything with a narrow majority of 52 seats.

The lack of consensus on how to pay for tax reforms and infrastructure spending means any revenue raising plan by the administration will be controversial, and Trump may have to resort to threatening a government shutdown to get his way. Woo said such a development would trigger a shift to less risky assets.

“Against this backdrop, we continue to think that the balance of risks points to lower U.S. rates and lower USD/JPY in September,” he added. “We favor selling USD/JPY as opposed to other USD crosses.”

Read: North Korean Missiles May Be Too Advanced for More Sanctions

Woo said brinkmanship over North Korea has become more likely because of the launch by Pyongyang of a second ICBM on July 28, and a statement by U.S. Secretary of State Rex Tillerson blaming China and Russia for growing tensions.

“For investors who want to hedge against a potential confrontation between the U.S. and China over North Korea over the next few months, we think selling KRW/JPY may be a better hedge than buying USD/KRW,” he added.

To contact the reporter on this story: Colin Simpson in Hong Kong at csimpson42@bloomberg.net.

To contact the editors responsible for this story: Christopher Anstey at canstey@bloomberg.net, Ravil Shirodkar