China and dumping US Treasuries .... You know they said it would never happen ? Well , "Never say Never" ....

ref :- "The threat of a US - China currency war ", Opinion by John Plender, The Financial Times

ref :- "China's Treasuries Hoard Seen as Next Line in the Sand After Yuan's Drop" , Bloomberg Markets 5/8/19 and updates

After Monday's market-mauling brought on by USD / CNY busting up through CNY 7.00, yesterday was a day for a breather. Encouraged by the People's Bank of China posting the official fix for USD / CNY at a stronger-than-expected rate (from which it is allowed daily moves of up to 2%), stocks were able to recover a little after six down days on the spin . Even the safe-haven seeking that has seen global bond yields tumble (and prices soar) abated for a while.

Frankly, though, this really does feel like a seminal moment for markets and the respite was pretty unconvincing. Sure enough, the PoBC's fix this morning was weaker than expected at only just under 7.00 and that was more than enough to rattle people's cages again. USD / CNY is pushing at 7.05 again, US 10yr Treasury yields are back down through 1.70% while German and UK equivalents are making record lows, and Gold has traded at $1490 per oz. . You could say that people are worried ...

Although China insists that the falling Yuan reflects economic fundamentals and is not a policy aim, there's little or no doubt that allowing the currency to weaken is a deliberate tactic in the trade war. Beijing has much less ammunition when it comes to imposing tariffs so must look for other ways to respond to aggressive moves by the US administration. A weaker currency is certainly one, and it was interesting to hear  US Treasury Steven Mnuchin joining his president in calling China "currency manipulators" ..... interesting because by the rules of his own Treasury Department, China does not qualify for that label. They would have had to be intervening in forex markets to weaken the Yuan (by selling it) ... which they haven't.

But the gloves are off in this fight, and old rules are out the window. For the US, it is not enough that China may not have been actively selling its own currency in order to weaken it. They have to have been actively supporting it to prevent the accusation. Not doing so makes them manipulators in US eyes, and the next logical step would be escalation from Washington .... possibly in the form of currency intervention of their own to weaken the dollar. It could turn out to be a vicious race to the bottom, currency-wise. Mind you, it's not terribly clear quite how the US would go about it, or indeed if it would be successful longer-term given the fundamentals behind dollar strength. No doubt the immediate reactions to US action would be pretty spectacular, though.

So .... if it goes all tit-for-tat in a currency war and China has run out of imports from the States to slap tariffs on, what other weapons might it bring in to play ?

China is the largest foreign owner of US Treasuries. It holds about $1.1 trn of US debt, or about 7% of the total. Now that's down from 14% in 2011 when China was playing a major role in keeping the head of the global economy above water, and down about $81 bn in just over a year. As John Plender points out, plainly .... and perhaps unsurprisingly .... China's appetite for financing America's huge (and growing) fiscal deficit is fading , but it's hard to imagine the market turmoil should investors come to believe that Beijing had decided to weaponise its holdings of US government IOUs.

The idea that China might dump its still vast holdings of US debt is one that's been mentioned a lot since the trade conflict began to get serious. Even though some fairly influential figures in China have on occasion mentioned the possibility of such a step, the idea has been rejected by commentators and for some pretty strong reasons .... most of which revolve around the idea that it would harm China more than would the US.

The consensus has been that selling Treasuries in such huge quantities would be bound to force yields higher  --  and prices lower  --  thereby incurring losses for China. Moreover, if the proceeds of the sales were to be repatriated to China, those losses would be compounded by a strengthening Yuan and a falling Dollar ..... a move that China wouldn't want to see anyway if a currency war was waging. It's a good point, but although it's not on the same scale bond yields have been falling (and prices rising) during China's reduction of Treasury holdings to this point. That's a function of safe-haven hunting of course, but who's to say that in the event of such roiling of markets another avalanche of haven-hunting might emerge to absorb Chinese selling and limit losses ?

Another huge factor arguing against the chances of a Chinese withdrawal is the question of what exactly would China do with it's $3.1 trillion of foreign currency reserves if they're no longer able to put a large chunk of it in the Treasury market ? No other government bond market , even that of the Eurozone, has anything like the same size and liquidity. And in case we'd forgotten, a huge and growing slice of the global bond market is trading with negative yields .... over $15 trillion of it. Just to labour the point, that means if an investor buys the bond and holds it to maturity, it's guaranteed to cost that investor money. Gold might sound attractive in those circumstances but the Gold market is far too small to absorb these sorts of numbers.

In normal circumstances, the arguments against a Chinese firesale are as strong as ever ..... but these are not normal circumstances. By letting USD / CNY slip through CNY 7.00, China has shown that it will consider things than previously it would have rejected. As the trade war / currency war escalates even further, there's no telling what provocative measures (as Beijing would see them) President Trump may take and what Beijing might do in response.

Mr Trump may think that he holds all the aces in this conflict but there's a suspicion that as a consequence of contrasting political systems if not cultures, China may be able to put up with more pain than Washington realises. Certainly, and as Stephen Roach of Yale University reminds us in the Bloomberg piece, China is operating on a much longer time-frame then a US president facing re-election next year.

You can't rule anything out .....