Rising tensions with North Korea should have investors boning up on the “Knightian uncertainty” hypothesis named after Chicago economist Frank Knight, who argued that when risk is not measurable, the distribution of possible outcomes is highly uncertain.

In these situations, investors typically seek out the safest of assets. But that has implications for the economy, including curbing gross domestic product growth and contributing to a rise in unemployment as investors flee riskier assets.

Such were results from a study by the Federal Reserve a few years ago that looked at periods when there was a flight to safety in 23 countries over a span of 30 years.

Market reaction in response to the news surrounding North Korea on August 10 and 11 was in line with the findings of the Fed study on the effects of one-day flight-to-safety effects. August 10 was perhaps a severe example, as seen in the correlations between assets and changing financial conditions.

At the least, the moves should be viewed as a wake-up call for investors, who have gotten too comfortable with the recent friendly environment markets.

There is usually one “momentum asset” that drives markets in these times. Good examples are Greek government bonds in 2010-11 and sub-prime mortgage bonds in 2007-08.

What momentum assets have in common is that they are illiquid, they trade with rising default risk, and they are systemically important such that they can impact the decisions of global policymakers.

At this time, it could be Korean stocks and bonds that become the next momentum assets. The country, whose gross domestic product is about $1.4 trillion, has a stock market of $1.46 trillion and about $750 billion of government debt securities outstanding.

Correlation and momentum are closely related, and the correlation between South Korean markets with global benchmark assets such as the S&P 500 Index, US 10-year Treasuries and credit spreads has begun to shift higher. A change in correlation that comes about as a result of two assets declining in value is a form of technical contagion. In the case of South Korea, the contagion could become more severe if foreign investors that have built large stakes in the nation’s equity and bond markets of near 15 per cent to 20 per cent decide to reduce their exposure.

Korean sovereign risk has been increasing since the start of the year, with credit-default swap tied to the nation’s government debt widening by 30 basis points. This comes with holdings of Korean bonds by foreign investors at the highest in five years.

An increase in Korean sovereign risk may impact positioning and, through rising correlation, ultimately financial conditions. Last week’s flight-to-safety episode saw a dramatic change in positioning in two “big short” trades that have been emblematic of this year’s global “risk on” rally: short positioning in long bonds and VIX futures.

The sharp reduction in positioning suggests a higher-volatility environment with lower long-term rates could be at hand, thereby tightening financial conditions. In an already benign inflation environment, policy normalisation by the Fed and other central banks may be delayed. The Knightian uncertainty surrounding North Korea is creating risks that are hard to model. As such, short-term traders may get the upper hand on longer-term investors, causing a change in market direction.

As we saw during the Greek sovereign crisis, correlation and technical contagion can quickly surface when markets are dealt with unknowns. For some investors, last week’s rout is a welcome blip of volatility to reinvest liquidity.

But for most investors, rising Korean sovereign risk is a clear warning. As many bond managers have already turned cautious and scaled back risk positioning, Knightian uncertainty could become a self-fulfilling prophecy whatever the next developments on the Korean peninsula may be.