Possible market implications for Chinese balloon

The big story over the weekend, at least as far as social media was concerned, was the Chinese balloon. The US claims it contained spy equipment, China says it was a weather balloon that went off course. The incident has plenty of political fodder, and has heightened tensions between Washington and Beijing. The first policy impact was US Secretary of State Blinken suspending a trip to China.

The incident has been both entertaining and worrying, depending on perceptions. But what does it mean for the markets? What can we trade here?

Is there more than just chips?

Even before the balloon was shot down, the issue of advanced semiconductors was already being discussed. Recently, the US, the Netherlands and Japan agreed on new restrictions on supplying technology to manufacture advanced semiconductors to China. Presumably, a spy balloon would need a substantial amount of chips to gather, process and retransmit information.

The main reason given for shooting down the balloon was to retrieve the payload. The analysis of the contents could reveal what kind of chips were used, and if they were supplied by the US or allies. The potential consequences imply another round of export curbs, particularly relating to advanced chips, on China. This is already an issue of growing tension between Taiwan, the US and China, since Taiwan is the world's pre-eminent manufacturer of advanced semiconductors, which in many cases are used by the US' defense mechanisms. (The Sidewinder missile used to take out the balloon likely had guidance chips manufactured in Taiwan).

Isolated incident or escalation?

China claims that it's a meteorological balloon that drifted off course. There have been reports of other balloons entering Latin American airspace, as well. Taiwan had previously reported similar balloons traversing its airspace, suggesting they were military meteorological balloons. China contends that it's a civilian balloon.

Both the US and China have announced they have "reserve the right" to take actions in response to what both are calling violations of international norms. However, beyond suspending a diplomatic trip, neither country has taken more concrete measures. With the balloon already shot down, internal US politics could overshadow the entire incident.

Possible next steps

The increased tensions between the world's two largest economies could contribute to some risk aversion in the near term. Particularly in the context of major central banks having just raised rates a few days ago.

Beyond that, the question is what happens if or when the payload is analyzed. The balloon was shot down over US territorial waters, and the debris are in relatively shallow waters that should allow at least some of the components to be recovered. However, analysis could take several months, meaning the incident could be revived in the future depending on what kind of components are found.

With global growth uncertain as China reopens from covid, potential of further export curbs could hurt risk appetite. Beyond that, the incident could end up being much more consequential to social media than to the currency markets.