President Donald Trump’s ongoing trade dispute with China is wreaking havoc on the Chinese economy, sending its currency and stock markets lower even as concerns deepen about forecasts of slowing growth.
China, as more and more observers are beginning to realize, simply can’t match the United States’ ability to lever up tariffs. It doesn’t import nearly as much from the U.S. as the U.S. does from China, and most of the goods that China does import are either products it doesn’t make domestically or are ingredients for China’s own exports.
With China’s back against the wall and Trump not close to relenting, some trade experts suggested that Beijing may finally be pushed to a “nuclear option”—selling its U.S. Treasury holdings.
That threat may be a long shot, however.
The recent prolonged weakness of the yuan fueled suspicions that China has been devaluing its currency as a form of retaliation against increased tariffs from the United States. During President Trump’s election campaign, he publicly railed against China’s deliberate efforts of “currency manipulation.”
Whether the yuan’s slide is due to manipulation or just market reaction to the softness of Chinese economic growth, Trump is keeping the pressure on.
“At the end of the day, the Chinese negotiation position is more complicated,” Robin Brooks, chief economist at the Institute of International Finance, told CNBC on Aug. 17. “They have tried to offset some of the tariffs the U.S. imposed by devaluing the RMB, and that didn’t work.”
“Hence, the move back to the negotiating table. I think it’s more of that than economic weakness,” he added.
Selling massive quantities of U.S. Treasuries and buying other reserve assets (bunds, gilts, or Japanese Government Bonds) isn’t easy to pull off. But should China enact this measure, what impact will China selling its Treasury portfolio have on the U.S. economy? And what toll would it impose on the U.S. economy, as some Asian commentators have suggested?
Bond Market Isn’t Sweating
There’s little precedent for the massive dumping of Treasuries. But data does exist regarding the relationship between the quantity of Treasury transactions and bond pricing and yield.In other words, purchases of Treasuries by central banks equating to 1 percent of GDP would typically generate a 5-basis point decrease in bond yields (bond yield moves inversely to bond price). Assuming the same dynamic applies to selling bonds—quantitative tightening—we can use the logic to predict the impact of any Chinese bond sales.
Federal Reserve to the Rescue
What does this entail? In theory, when Treasury prices decline, rates will increase. This should also drive up the interest rate on consumer and commercial debt such as mortgages, car loans, and corporate bonds.Extrapolating this effect to the broader U.S. financial markets, investors may choose to dump stocks and buy bonds, because of higher expected yields from fixed-income instruments compared with risky assets.
If this situation sounds familiar, it’s because it had been playing out following the last financial crisis. Since the rest of the U.S. economy is on sound footing today, this trend alone would be straightforward to fix. The Federal Reserve will likely reverse its current monetary policy path and begin weakening instead of tightening. It can reassure markets by starting QE all over again and buying up Treasuries.
Circling back to the U.S.–China tug of war, this scenario weakens the U.S. dollar against the yuan. Over time, U.S. exports will appear more attractive to foreign buyers and Chinese exports would suffer.
All of this brings Beijing back to its existing strategy: devaluing the yuan.
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