Attack by North Korea triggers flight to safety

Risk sentiment suffers serious deterioration

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Risk sentiment suffered a serious deterioration as North Korea’s bombardment of a South Korean island added a fresh layer of uncertainty to markets already burdened with concerns about eurozone debt and the tightening of Chinese policy.

Global equities, commodities and the euro came under heavy selling pressure as investors sought safety in the dollar and the “core” government bonds of the US, Germany and the UK. Gold also rose, in spite of the dollar’s firmer tone.

“The market mood has darkened considerably as a cluster of headwind factors have resurrected fears about a fragile global financial system, outweighing the positive signals from economic figures that point to a continued expansion,” said Lena Komileva, head of G7 market economics at Tullett Prebon.

News of the sudden escalation of tensions in the Korean peninsular came too late to have much immediate impact on Seoul’s stock market but left the Won currency sharply lower against the dollar.

Analysts said the markets would remain sensitive to further developments in the region but the general view was that the situation would most likely be limited to “sabre-rattling”.

“Despite the increasingly erratic behaviour of the North Korean regime, we still view a full-blown war between the two Koreas as only a remote possibility,” said Flemming Nielsen, senior analyst at Danske Bank. “The incident’s impact on the financial markets is likely to prove temporary.”

Meanwhile, mounting concerns that Ireland’s debt crisis could yet spread to other eurozone nations continued to weigh on the euro and on peripheral government bonds.

“The speed at which the European markets fell back into fearing sovereign and banking risks after Ireland agreed to a bail-out by its EU partners is a worry,” said Greg Gibbs, FX strategist at RBS.

The single currency sank more than two cents to trade below $1.34, its weakest level since September.

The yield spread between Irish and German 10-year government bonds widened 45 basis points to 589bp, while the five-year Irish credit default swap spread, a measure of the cost of insuring against a sovereign debt default, soared 46bp to 578bp, according to Markit.

Portugal, widely seen as next in the market’s line of fire, saw its spreads approach 500bp with concerns heightened by news that the country’s budget deficit had widened in the first 10 months of 2010, in spite of higher tax revenues.

Significantly, the Spanish-German 10-year spread widened to its highest level since the introduction of the euro.

An auction of short-dated Spanish Treasury bills produced less than impressive results, with yields rising sharply.

Divyang Shah, strategist at IFR Markets, highlighted growing concerns about Spain’s banking system.

“These concerns had subsided following the European [bank] stress tests in July but have made a comeback as the bail-out for Irish banks confirms that the stress tests were not stressful enough,” he said.

The intensification of geopolitical and sovereign debt worries prompted a sharp sell-off in global equities.

The S&P 500 was down 1.4 per cent while the FTSE Eurofirst 300 was also 1.5 per cent lower.

In Seoul, the Kospi index ended with a loss of 0.8 per cent but after-hours index futures tumbled and Hong Kong shed 2.7 per cent, its biggest drop in six months. Japanese markets were closed for a holiday.

The flight from risk triggered broad gains for core government bonds, with the 10-year US Treasury yield down 4bp to 2.76 per cent and the German Bund yield 11bp lower at 2.55 per cent.

In commodities, oil recovered the $81 a barrel level but was still down, while copper neared a one-week low. Gold climbed to just above $1,375 an ounce.

There was little market response to the day’s main economic releases. US third-quarter growth was revised up to an annualised rate of 2.5 per cent from 2 per cent. The Federal Reserve’s open market committee minutes stressed that its easing programme would not be tied to economic data.

The eurozone purchasing managers’ indices came in stronger than expected, flagging a solid re-acceleration in both factory and services activity.

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