Amid an escalating, tit-for-tat trade battle, some investors fret China could be tempted to sell a large chunk of its stockpile of Treasurys in a bid to raise U.S. government’s borrowing costs when Washington is contending with trillion dollar annual deficits.
Hu Xijin, the editor in chief of Chinese state-owned newspaper The Global Times, tweeted on Monday that Chinese scholars had discussed selling the country’s stockpile of Treasurys as one potential option to retaliate against the U.S., after Trump hiked tariffs on $200 billion of imports last Friday to 25% from 10%.
China may stop purchasing US agricultural products and energy, reduce Boeing orders and restrict US service trade with China. Many Chinese scholars are discussing the possibility of dumping US Treasuries and how to do it specifically.
— Hu Xijin 胡锡进 (@HuXijin_GT) May 13, 2019
This isn’t the first time that trade tensions have stirred worries over China’s Treasury hoard. Bloomberg in January 2018 reported that Chinese government officials had recommended slowing or halting purchases of Treasurys, contributing to a temporary bond-market selloff at the time. China’s foreign-exchange regulator later dismissed the report as “fake news.”
More recent, rumors abounded that the lackluster showing in last week’s Treasury auctions to fund the U.S. government over the next two quarters may have been due to China, the U.S.’s biggest creditor, curtailing its purchases of debt, said market participants.
Yet many remain doubtful that a Chinese pullback from the U.S. bond market, dubbed the “nuclear option”, would work as advertised. Here are three reasons why skeptics are playing down the threat.
If China ran down its more than $1.1 trillion of Treasury holdings, investors would perceive the maneuver as a sign that Beijing remained unwilling to back down to U.S. demands, and that an eventual resolution to a trade clash stood far away.
An escalation of trade tensions and the increased headwinds they would present to a rebound in global growth would prompt investors to take shelter in haven assets such as U.S. government paper. A heightening of trade tensions would thus offset any move by Beijing to pressure U.S. borrowing costs higher.
“One current point of focus is the market response to potentially increased selling of Treasurys out of Beijing. In general, we would expect Treasurys to continue richening as the first order price impact comes from the flight-to-quality flow and diminished growth expectations…On net, growth and fundamentals will overwhelm flow,” wrote Ian Lyngen, an interest-rate strategist at BMO Capital Markets.
Even after the tweet from The Global Time’s editor, Treasury yields remained lower as the stock-market tumbled. On Monday, the S&P 500 SPX, +0.80% dropped more than 2% and the Dow Jones Industrial Average DJIA, +0.82% shed nearly 600 points, while the 10-year Treasury note yieldTMUBMUSD10Y, +0.33% fell 5 basis points, and was at risk of falling below the 2.40% level. Bond prices move in the opposite direction of yields.
Lessons of history
Investors point to history to demonstrate the relationship between China’s Treasury holdings and U.S. borrowing costs isn’t so clear-cut, despite Beijing’s status as the U.S.’s largest creditor.
China has sold a sizable portion of its Treasury stockpile back in 2015-2016, when domestic growth was slowing and raising concerns around the health of the global economy.
Speculators shorted the yuan in anticipation that China’s excessive debt levels would force the second largest economy into an abrupt slowdown. To stem the yuan’s USDCNY, -0.0349% weakness, China sold close to $500 billion of U.S. government paper.
But even this failed to dent Treasury prices. In the summer of 2016, appetite for haven assets pushed the 10-year note yield to a record low of 1.32%.
Even if paring back its presence in the Treasurys market lifts U.S. borrowing costs, the retaliatory move would also erode the value of the mainstay of China’s foreign reserves. Guy LeBas, a fixed-income strategist at Janney Montgomery Scott, argued such a move would be akin to cutting off one’s nose to spite the face:
(B) The Chinese gov't is ready to start warning about such. It's a cut-your-nose-off strategy for China, since their reserve funds are single largest holder of Treasuries. 3/
— Guy LeBas (@lebas_janney) May 13, 2019
In addition, Patrick Chovanec of Silvercrest Asset Management said selling Treasurys would weaken the U.S. dollar against the yuan, preventing Beijing policy makers from offsetting the impact of tariffs through a weaker Chinese currency.
China dumping US Treasuries and then selling the dollars it gets for other currencies would also put downward pressure on the USD – which is the exact opposite of what China wants, to help mitigate the effect of US tariffs.
— Patrick Chovanec (@prchovanec) May 13, 2019
Lack of options
All in all, analysts say China has few choices for foreign-exchange reserves other than Treasurys, which carry much higher returns than ultralow or negative-yielding government bond markets in Europe and Japan.