China has no good choices

What to Worry about Today: Hypocrisy.

With an eye on the midterm elections, Trump is positioning Chinese tariffs on US exports as interference in domestic affairs by a foreign power, He said China is “actively trying to impact and change our election by attacking our farmers, ranchers and industrial workers because of their loyalty to me.” The hypocrisy is breathtaking even for Trump, who does not acknowledge Russian interference in the 2016 election.
China has no good choices. If it continues talks, China is at risk of being blind-sided again, since Trump refuses to become educated on the basic economics by Kudlow and Mnuchin. US tariffs are a political ploy, not a policy. China takes a long view, which it can afford since it will not be holding any more elections now that Xi is leader for life. Perhaps China will just wait until Trump is gone, at which point it will have a strong hand with the next president, having suffered insults and real grievances. Or maybe China will feel compelled to save face by real retaliation. Because trade is so lopsided, it can’t match Trump tariff for tariff. What else does it have? Dumping US Treasuries.
Chinese dumping would send prices far lower and yields higher. Bond gurus believe China holds US paper of all maturities and a lot depends on which tenor gets sold. It’s possible that sales of 10-years might not have much immediate effect because there is so much demand for yield worldwide, Longer run, the absence of a big buyer sends yields lower. Some say big sales at the shorter end of the curve—where the Fed is most powerful—result in a drop in prices and rise in yields that flattens the yield curve even more, if not inverted. But perhaps the absence of a big buyer at the longer end of the maturity scale offsets this effect. A flat or inverted yield curve generates chatter about recession.
It doesn’t serve China’s interests for the US benchmark 10-year yield to be driven so low it is competing with the likes of Nigeria (15.21%), but it would certainly be appealing to have the yield driven so high that the Chinese 10-year gives the appearance of reflecting less risk. The Chinese 10-year is 3.667%, not all that far from the US 10-year at about 3.05%. The question is whether dumping some $1 trillion into the $21 trillion US market would move the yield that much. See the chart from MarketWatch (Aug 23).

Then there is the announcement effect. If China were to say it’s going to dump Treasuries, it might set off a stampede. See the list of holders from the same MarketWatch article. The UK, Switzerland, Luxembourg and Caymans disguise the true owners, usually thought to be Middle Easterners but probably also various dictators and oligarchs. The question becomes whether these holders become contaminated. And if they do, so what? About 70% of the US debt is held by US citizens and entities. An initial spike would likely be followed by a full or nearly full recovery.
Also interesting is what the rating agencies will have to say. Having been the point man for a rating agency audit at a big bank and having seen what the agencies did to contribute to the 2008 melt-down, we lack respect. But ratings are still a core necessity and if China were to dump a significant amount, say most of its $1.18 trillion, would the agencies consider the US should be downgraded because of the high debt-to-GDP ratio and lousy prospects for funding? Well, we have been downgraded before, and came back. The US is the biggest and most resilient economy on the planet, despite sometimes suffering from Third World mismanagement.
It is generally accepted that China would have a problem finding a place to park the money if it exits the US market. In fact, there are plenty of other countries with ratings equivalent to the US today, triple A or its close cousins, eleven to be precise.  Tradingeconomics.com has a list showing results from the four big agencies. It contains the usual suspects (Canada, Australia, New Zealand; Denmark, Germany, Belgium, Austria, Luxembourg, and Sweden, Switzerland and Taiwan. We didn’t add up the issuance of all these countries but together they could probably digest $1 trillion. Or China can go downmarket and add in some BBB names, like Spain and Romania.

So, China could dump Treasuries and it would cause a Shock, if not likely a long-lasting one. The whole global financial systems would re-jigger itself in pretty short order. The US bond market would hardly go down the drain. You can bet that every big trading desk already has a contingency plan.
Most analysts, including us, think dumping Treasuries is not in China’s best interests, not least because the announcement effect alone would devalue the dollar and these assets are, after all, dollar-denominated. But longer run, China has not been shy about wanting the yuan to become one of the top global currencies and someday to replace the dollar as the top reserve currency. We argue that this cannot happen until the currency floats truly freely, capital markets are varied and well protected by law, and this Communist country acknowledges private property rights over the rights of the state.
The trade crisis is forcing China to contemplate reforms it thought it had a few more decades to develop. In the weird way history sometimes takes an odd path, Trump could have inadvertently accelerated reform in China…. Interesting to contemplate, if hardly the outcome anyone expects now.
Bottom line: China will probably not dump Treasuries because the US can recover fully and quickly. A global financial Shock set into motion by dumping Treasuries will be unpleasant and frightening for a while and could have unforeseen consequences. The worse the Shock, the more China gets blame and opprobrium. Is that the same thing as losing face? Probably, because it makes China look as petty and vindictive as Trump.
If China is going to strike back at the bully, it needs a tool that will carry a heftier punch. We don’t know what that might be except yuan devaluation.  Chinese premier Li has repeatedly said the yuan will not be employed as a weapon in the trade war, but when the rubber meets the road, that could go out the window. The rubber meeting the road comes in the form of a significant slowdown in the Chinese economy or specific sectors.
Besides, here’s the good news: Kudlow and Mnuchin know all this. Trump and his Trade Office/Commerce Dept keep dissing these two guys who argue against tariffs, especially the scale and scope of Trump’s tariffs, but it’s conceivable Trump will listen to them when it comes to money per se. If not, what the hell are they teaching at Wharton? If the US and China continue to talk behind the scenes and there is a threat of dumping, we should assume Kudlow and Mnuchin will smell it. Whether they can get Trump to dial it back is another matter. Meanwhile, the latest TICS report shows foreign investors bought $18.9 billion of securities maturing in more than one year. This makes the point that demand for US paper is hardly on the defensive.

Outlook: The talk of China dumping some or all of its US sovereign debt as retaliation for the Trump tariffs is running alongside other questions about yield. In practice, these other questions are the dominant ones. Yesterday, when the 10-year yield broke the 3% barrier for the first time since May, analysis was all over the place. Some writers wanted to stress that exceptionally big corporate issuance was to blame for subtracting government paper buyers. Others said Hey! The Fed is hiking next week and likely again in December. The 10-year yield should get pushed up for that reason alone.
A Raymond James bond guru told the FT that the rise in short-term rates may actually cap inflation and end up suppressing longer-term yields. “As we pass back and forth through 3 per cent on the 10-year note, it becomes more and more evident that we don’t really know who is in control here.”
This is one of the scariest things we have ever read in the FT. Something else that is scary is the relentless rise in the Swiss franc, or rather the big drop in the dollar against the Swissie. See the chart in the Chart Package. Some analysts say that with traders already positioned as long dollars as they can stomach, the Swiss franc is the risk-off haven. If so, when EM currencies get a respite, you’d expect the Swiss franc to retreat. Today as emerging market currencies are stable to recovering, the dollar/CHF is on the rise, too, so this is perhaps a good enough explanation. Lining up the Turkish lira and Argentine peso against the Swiss franc, the correlation is fairly weak, though.
In addition, “commodity currencies” AUD and CAD are outperforming. Wait a minute—if China is going to lose some 0.5% to 0.8% in GDP because of the trade war, shouldn’t demand for commodities be expected to fall?
Bottom line, the bond market is somewhat confused about why prices are moving the ways they are, and so is the FX market. One of the few salient points to take away is that the FX market is up to its eyeballs in long dollar positions and at some point, even without a specific trigger, traders will want to pare back.

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