LONDON (Reuters) - One of the foundations upon which the economic and financial relationship between the United States and China over the past 15 years has been built is the assumption that Beijing won’t sell its vast holdings of U.S. Treasuries.
The financial damage to both countries, and the potential fallout beyond the monetary effect, would be so profound that it simply wouldn’t happen, so the theory goes. Disregarding this would be the economic superpower equivalent of the Cold War’s ‘mutually assured destruction’ doctrine.
But with trade tensions between the two countries escalating dramatically, it may no longer be a total long shot.
It’s a scenario being contemplated now more than at any point in recent years, certainly since August 2015, when fears of a Chinese downturn spooked global markets and prompted a mini currency devaluation from Beijing of around 2.5 percent.
Google news searches in the United States for “China Treasuries” and Google web searches in the United States for “China selling Treasuries” are now both at the highest since August 2015.
It is back on the U.S. public’s radar, at least. And if the trade war further escalates, as most observers believe, it won’t be long before it comes back onto the bond market’s radar too.
The Trump administration imposed 10 percent tariffs on $200 billion of imports from China this week, and Beijing hit back immediately with tariffs on $60 billion of U.S. imports.
However, the pool of U.S. imports China can target is relatively small, so it may opt to weaponise the exchange rate and allow the yuan to fall much more against the dollar than the 10 percent it has already slid since March.
That was before the tariffs, but Beijing has since pledged not to go down the devaluation path to offset their impact. So if China wants to lean against any downward pressure on the yuan, it may have to sell some Treasuries anyway.
That leaves its $3.11 trillion pile of FX reserves, $1.18 trillion of which is in U.S. Treasuries. It could allow that portfolio to run down, slow or halt further purchases, or go all the way and sell bonds outright.
We’ve been here this year already. In January Beijing denied a media report that Chinese officials had recommended slowing or halting purchases of U.S. bonds amid a less attractive market for them and the rising trade tensions.
“The news could quote the wrong source of information,” said the State Administration of Foreign Exchange, adding wryly, “or may be fake news”.
The impact on U.S. yields is highly debatable. The U.S. Treasury market is a $15.7 trillion market so a slower pace of accumulation, no buying at all, or even outright selling from China would be easily absorbed.
Some analysts believe market “flow” has zero impact on yields anyway and what really matters is expectations for Fed policy. Others reckon it does, but only at the margins, at best.
Brad Setser, a former economist at the U.S. Treasury and an expert on global capital flows, estimates that, all else remaining equal, China unwinding its entire portfolio could lift the 10-year U.S. yield by 30 basis points initially.
Even a 60 bps rise, while painful, would ultimately be bearable, Setser wrote in a paper in June. And Washington has the ultimate ace up its sleeve: “The Fed is the one actor in the world that can buy more than China can ever sell,” he noted.
Still, it would be uncharted and potentially dangerous territory. U.S. bonds are coming under pressure as the economy drives ahead and the Fed keeps on raising rates and shrinking its balance sheet.
New supply of bonds is soaring as the Treasury issues debt to pay for Trump’s $1.5 trillion tax cut. The 10-year yield is rising again and back above 3.00 percent, a psychological barrier, if nothing else.
What’s more, China’s demand for U.S. bonds probably isn’t as strong as it was. China’s economic boom over the last couple of decades largely relied on the U.S. consumer. The huge surplus was ploughed back into U.S. Treasuries, which built up FX reserves for Beijing but also helped keep U.S. bond yields low, the U.S. economy humming and the U.S. consumer spending.
China’s growth is now half what it was pre-crisis and is set to slow further. That growth is arguably now less reliant on exports, and the current account surplus is a fifth of what it was a decade ago.
Could China start winding down its U.S. bond portfolio? We may be about to find out.
The opinions expressed here are those of the author, a columnist for Reuters.
(Reporting by Jamie McGeever; editing by David Stamp)