by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] We are seeing a continuation of yesterday’s market activity, with equities coming under pressure and sovereign bond yields falling around the world.  Commodity prices are falling with equities, and the dollar is strengthening along with the yen.  The weakness we are seeing in equities isn’t anything out of the ordinary, but the action in sovereign debt is truly extraordinary.  As we noted yesterday, over $10 trillion of sovereign debt is now trading with a negative yield.  Some of what is occurring in the sovereign debt area is due to continued QE in Europe and Japan.  It is possible that the BOJ will announce an increase in QE next week.  However, there does appear to be growing fear in the markets.  The U.S. employment data is raising concerns about the American economy, the political situation in the U.S. is unsettling as well, the ECB’s expansion into the buying of corporate bonds for its balance sheet is troubling (some of the bonds look less than stellar in terms of credit quality), and there are worries about Brexit and other geopolitical risks, as we note below.

Today’s NYT reports that, for the first time, China sent a warship into the disputed waters of the Senkaku Islands (Diaoyu Islands as named by China).  This group of small, uninhabited islands is near Taiwan and situated roughly in line with some of the small, southernmost islands that are part of Japan.  Both China and Japan claim the islands as part of their territory.  These islands are a “flashpoint” in that neither side wants to be seen as backing down on this issue of sovereignty.

China regularly sends civilian vessels (including China’s Coast Guard) around the islands where they are usually engaged by Japan’s Coast Guard.  Sending a naval vessel (specifically, a Jiangkai I frigate) is a clear escalation of tensions.  This action coincides with an increase in China’s aggressive air patrols, including threatening U.S. military aircraft flying in international areas in the South China Sea.   In another twist, two Russian naval vessels were spotted in the islands’ waters, the so-called “contiguous zone,” which is a 24 nautical mile area around the islands; it is not clear if they were working in concert with China or just happened to be in the area.

This action is an alarming development.  First, it’s becoming abundantly clear that China is escalating tensions in the region.  The key question is “why now?”  As we warned in mid-December in our 2016 Geopolitical Outlook, nations at odds with U.S. hegemony realize that there is a good chance that the next president will take a harder line with “miscreants” than the current occupant.  Thus, it makes sense to challenge America’s allies across the world to try to influence the allies’ behavior before the new president takes office.  Second, China is facing an increasingly unstable economic situation and it is not uncommon for nations dealing with economic issues to try to distract their citizens with nationalism.  China likely assumes that the U.S. will not support Japan in a conflict over uninhabited islands.  Third, Russia is clearly at odds with the U.S. and wants to solidify its relationship with China.  Supporting China by putting its warships in the same area will help make the U.S. look weak and, at the same time, enhance its relations with China.

It should be remembered that the contiguous zone around these islands are international waters.  Russian and Chinese ships can pass in these waters legally.  Still, Beijing knows these moves are provocative and are designed to send a message to both Tokyo and Washington.  Due to the media attention surrounding the presidential campaign, the situation in the waters around China is not getting much attention.  This is unfortunate because China and Russia’s actions should not go unchallenged, because if they are, it is highly probable that more aggressive moves will follow.

Yesterday, the Federal Reserve released the Financial Accounts of the U.S., formally known as the “flow of funds” report for Q1.  The report is packed with lots of interesting information.  Here are a few of the charts that we think are worth noting.

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