China's $1 Trillion Treasury Holdings Is Not A Useful Trade Negotiating Weapon

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Includes: EGF, FIBR, FTT, GOVT, PLW, TAPR
by: Tim Worstall

Summary

China does indeed hold $1 trillion or so in U.S. Treasuries.

Some think that if it sold them, chaos would ensue; some nuclear option exists.

There might be a blip in prices or yields, but it's just not a big enough thing to cause real problems.

There's an old joke - originating with Keynes himself which is why the numbers rather need updating for inflation - that if you owe the bank $1,000, then you've got a problem; if you owe them $1 million, then the bank does. That's true, but it's whether the amount is existential, which is the dividing line between the two forms of problem.

So it is with this idea that because China owns $1 trillion or so of U.S. Treasuries, it would be the U.S. that has the problem, not China:

Xi will certainly be hoping Trump's cordial welcome was for real, because China has much more to lose economically from a trade war than America does. This might sound counter-intuitive given that Beijing can deploy the economic nuclear option if Trump makes good on his campaign pledge to slap whopping tariffs on Chinese imports. The US owes China more than $1 trillion and Xi could send America's economy into a tailspin by sanctioning a dumping of US Treasury bonds.

But the problem with nuclear missiles is that they are never really intended to be fired, and if they are, there are no winners. Sure, China could cause enormous damage to the US, but only by damaging itself.

The Guardian there is just an example of the argument; it's one that's common enough around this here Internet isn't it?

And the true answer is that it's not really a problem at all. Sure, it could cause a bit of indigestion in the markets, but it's simply not an existential problem. The Treasury market is simply too large for it to be such a problem.

For example, and it is debt held by the public we want leave aside the various trust funds and lock boxes, there's some $14 trillion in Treasuries of various maturities out there:

China's holdings are therefore some 7% or 8% or so of the market. Yes, one seller marching in one day to sell that amount will cause some indigestion. But it's still not a vast amount given the size of the market. Daily turnover is in the $400 to $500 billion range after all. Two day's trading volume is not exactly the terror of the ages.

So, an initial look at the rule of thumb would be that it wouldn't be exactly easy for the market to absorb all of this, but we're not talking about anything disastrously out of the ordinary.

Yes, of course, prices would fall and yields would rise with that level of selling. But we'd not immediately think that it would be a huge or massive change in price. Flows of buying and selling in specific stocks double or even triple quite regularly on a daily basis, don't they?

But let's say that I'm or we're being too, just too, languid about this. Say that it all comes as one big sell order and the market panics. What is going to happen then? Well, the Federal Reserve has quite a balance sheet at present:

That 4M on the right hand side should be read as $4 trillion. So, in the past eight years, the Fed's balance sheet has expanded by over $3 trillion. Of course, the name we give to this is quantitative easing. And the entire point of it was to raise the price of Treasuries, lower the yield upon them, and thus, tempt people out further along the risk curve in search of yield.

So, if necessary, who doesn't think that the Fed would, or at least could, expand that balance sheet by another 25%? That's most certainly not a bet that I'd want to be making.

We can also go one stage further here which is to look at the recent FOMC minutes. Where one of the discussions was about how and when to reverse QE. The decision, at least so far, is sometime later this year and to do it gradually. Those bonds it's holding currently mature at a certain rate each month. The Fed then takes the principal repayments and buys more bonds (both Treasuries and MBS) in the markets in order to maintain the stock. The general method of running down QE will be to stop doing that. To collect the principal repayments, the issuer then has to issue new bonds to the market to roll over the debt. The Fed sends the principal sum collected back down into the computer systems which invented the money in the first place and cancels it.

Quite how fast it's going to do this is unknown and it'll most certainly be a bit tentative at first. But the amounts maturing are of the order of $20 to $40 billion a month. We can check that; the weighted maturity of the holdings is about 120 months, so that looks about right as the portion maturing in any one month.

It's entirely true that $20 billion is less than $1 trillion, so is $40 billion. But it does offer us a useful size comparison. China's Treasury holdings are some two to three years' worth of the Fed's possible unwinding of QE. That is, $1 trillion is a heck of a lot of money, but with regard to the markets we're talking about, it's not in fact a great deal.

We might have one stab at worrying more about this, which is what if the Chinese sell and then sell the $s they get? Won't that make the value of the $ plunge? At which point it's worth recalling that $1 trillion is less than a day's action in the foreign exchange markets. It's actually less than a day's action just in and out of the U.S. dollar, let alone all the other currencies out there. So, again, sure, prices will change, but we're just not talking about something that is existential in any manner.

Keynes was absolutely correct, whether debt is a problem and to whom depends upon how large that debt is. But while China really does have a trillion $s of U.S. Treasuries, that's just not a large enough number to seriously be a problem to the U.S. As such, and don't for a moment believe that the Chinese don't know this, it's not really much of a weapon. Sure, everyone would prefer that the stake doesn't run up bright and early one sunny morning. But if it did, with most assuredly a wobble or two along the way, the system would be able to cope with it.

$1 trillion just isn't a large enough amount to be a weapon these days.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.