China's Rapid Response to Tariffs Raises Treasuries Risk, for Some

  • ‘Everything is in play right now’ in trade spat: fund manager
  • Just one headline could affect rates markets: Deutsche Bank
Macquarie Capital’s Thierry Wizman discusses the potential for China to retaliate against the U.S.

China’s swift response to President Donald Trump’s tariff proposals has again raised the specter of the largest foreign holder of U.S. Treasuries running down its holdings.

The retaliation on Wednesday, with mooted levies on $50 billion of U.S. imports -- the same value as Trump’s targets -- took many by surprise. Coming less than 12 hours after the U.S. list, the move was “faster and a bit larger than expected,” Morgan Stanley economists said. Ahead of the announcement, veteran analysts at Evercore ISI reflected the view of many, predicting no quick reprisal from China.

So what happens next?

“Everything is in play right now, because we are in the initial stages of negotiating with both sides trying to play hardball,” Jack McIntyre, a fixed-income portfolio manager at Brandywine Global Investment Management in Philadelphia, said by email, referring to the potential for China to cut its stock of Treasuries.

While McIntyre doesn’t see that happening, he says his fund is positioned for the possibility, with underweight holdings of Treasuries relative to his benchmark.

‘All Options’

Few China watchers would disagree with McIntyre that dumping the country’s vast holdings of Treasuries, officially standing at $1.2 trillion, represents a nuclear option. After all, it would impose losses on China itself, and potentially cause mayhem in the world’s deepest bond market. And China declined the idea of abandoning U.S. securities when Russia proposed it in 2008, according to Henry Paulson. (China and Russia officially rejected the former Treasury secretary’s account.)

Yet it’s also true China’s ambassador to the U.S., Cui Tiankai, said last month “we’re looking at all options,” when asked about the potential for scaling back Treasuries buying. He warned financial markets would be among the casualties of U.S. unilateral action. Earlier rumblings came in January, when Bloomberg reported that officials reviewing China’s foreign-exchange holdings recommended slowing or halting Treasuries purchases.

The official stock of Chinese holdings has come down from mid-2017, even as the yuan appreciated. The size of the pile had soared in the past as officials acted to stem currency gains.

Vice Finance Minister Zhu Guangyao said China is a “responsible investor,” at a press conference in Beijing Wednesday, after he was asked whether the country would use its Treasury holdings to strike back against the U.S. He reiterated comments from Premier Li Keqiang last month, saying China manages its reserves in line with international capital market rules, according to the state-backed Xinhua News Agency.

Read more about who’s buying and selling Treasuries here.

“China will probably reduce its net purchases of U.S. Treasuries, as it has done from the beginning of the year -- but more rapidly,” predicted Alicia Garcia Herrero, chief Asia-Pacific economist at Natixis SA in Hong Kong. “This should push up longer term yields in the U.S., but also widen spreads of investment grade U.S. credit,” she said by email Wednesday.

Garcia Herrero’s scenario is different than a move to sell Treasuries outright, which could prove destabilizing even to China. A sudden plunge in the dollar would cause yuan appreciation that could hit Chinese exports more powerfully than the tariff hikes proposed by Trump.

Dumping Dollar

"If they were to do that, they could conceivably cause a panic-sell in the dollar” as other asset managers cut U.S. debt holdings to limit losses, said Thierry Wizman, a global interest-rates and currency strategist at Macquarie Group Ltd. in New York. "It’s more likely that they would use the FX lever before they would use the interest-rate lever,” he said, adding that even pursuing depreciation of the yuan is unlikely at this point.

Garcia Herrero also flagged the potential for “staggered depreciation” in the yuan as a Chinese response to Trump.

In the Treasuries market, China wouldn’t have to actually sell in order to send shivers through trading, especially as the U.S. government ramps up borrowing to fund a widening fiscal deficit.

“Even a simple headline, with China reminding the U.S. of this number, could be a risk to U.S. rates,” Torsten Slok, chief international economist at Deutsche Bank AG, wrote in a note Wednesday, referring to China’s $1 trillion-plus portfolio. “This new risk adds to the already long list” of reasons to be wary of Treasuries, he wrote -- from rising borrowing needs to upside risks for inflation.

— With assistance by Sarah Ponczek, Ramy Inocencio, Narae Kim, and Emma O'Brien

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