This may seem counterintuitive given that most worries in regards to the side-effects of the spiraling trade war situation between the US and China and to a lesser extent between the US and some of its historical friends such as Europe and Canada have been in regards to what effect it may have on the economy and on the stock markets as a result. The stock market selloff that we are seeing take shape now that the threat of global trade being disrupted by tariffs is finally being taken seriously by investors, is seen as being a reason to expect a bond rally. After all, money moving out of stock markets needs to go somewhere and that somewhere generally tends to be government securities. It seems that very few people are concerned about reasons that some very important US treasury holders may have to sell. The further escalation of the trade war may, in fact, remove all logical strategic and economic reasons for countries like China to continue to hold on to its US treasury bills.
Trade War Escalation
While The Trump administration has threatened to target EU and Canadian car exports to the US next after the first round of tariffs and counter-tariffs, the trade war between the US and China is becoming more intense. By July 6, we could be looking at tens of billions of dollars' worth of goods flowing in both directions being hit by steep tariffs. Once the tariffs and counter-tariffs will be implemented, we could be looking at $100 billion worth of goods in total targeted by both sides. The Trump administration views this as a trade war that the US cannot lose because it figures that with the disparity in US exports to China versus Chinese exports to the US being so big, China will eventually run out of targets for tariffs, while the US will still have plenty of goods it can target long after China runs out.
Source: The Independent.
The US is thinking very similarly in regards to its relationship with the EU, which also runs a significant trade surplus with the US.
Chinese Holding Of US Treasuries Was Always About Facilitating The US Consumer's Ability To Keep Buying Chinese Goods
While the Trump administration seems to only consider China's ability to impose counter-tariffs as being a tool of fighting back in this trade war, China does have another major weapon at its disposal, in addition to some other more minor tools it can deploy in order to undermine America's economy. It currently holds almost $1.2 trillion in US government debt, which has been more or less the level of US debt it has been holding since 2010.
Source: Financial Times.
In the past decade or so, its holdings held steady. In my view, China's role as financier of indirect American consumer spending was taken over by the US Federal Reserve, which bought about $2 trillion worth of US Treasury debt since the beginning of 2009. This is a trend that the Federal Reserve decided to wind down a while ago and it has recently reversed the trend, becoming a slight net seller.
Source: Federal Reserve Bank of St. Louis.
While China had a good reason to keep buying US debt up until 2010 and was probably very grateful to the US Federal Reserve for assuming the role of keeping the US consumer spending, in the event that the Trump administration will continue with its policy of ratcheting up trade tariffs against Chinese goods, I fail to see what reason China will have to hold on to those US treasuries. In fact, it may have to start selling simply due to its need to free up funds needed to shore up its own economy. Given that US consumers will no longer be buying Chinese goods in a significant enough volume to make it worthwhile for China to keep financing America's tendency to consume more than it produces, it will likely start selling US treasuries very aggressively.
US Bond Market May Be Overwhelmed
The US bond market is already facing pressures from the reversal of the Federal Reserve's policy of being a net buyer of US debt as well as a growing US fiscal deficit. For the current fiscal year, the deficit is now projected to surpass $800 billion by the CBO. By 2020, it is projected that it will surpass $1 trillion and it is projected to keep growing going forward. We should keep in mind that these projections do not include the increasingly real prospect of an economic recession, which could easily lead to a doubling of deficits, due to higher spending needs as well as reduced revenues.
Ordinarily, a sort of a natural balance tends to occur where higher deficits due to an economic downturn are financed by money moving out of the stock markets and going into bonds. In other words, the government gets to borrow money cheaply, which it uses to keep recessions shallow by not cutting spending in order to prevent higher deficits and even engaging in economic stimulus programs. Given the size of the US stock market, which is about $30 trillion, it is easy to see why a significant stock market selloff generally tends to lead to bond yields moving lower in response to money flowing out of the stock markets. A simplistic view would suggest that every 1% decline in the total value of the stock market in effect provides about $300 billion in cash available that could potentially flow into the bond markets. Of course, not all of it does flow into the bond markets, and the whole thing is actually a bit more complicated, but needless to say that a recession will in all likelihood make a lot of cash available as stock markets sell off. Not to mention that there can be significant foreign inflows of cash as a flight to perceived safety feeds on itself.
With so many sources of increased supply, there is a chance that the well-established pattern we have seen recession after recession could break down. A significant potential seller like China showing resolve to dump such a large supply of US bonds on to the market at a time when deficits are already providing plenty of supply could cause a rush towards the exit door, just as one might expect the opposite to happen. It would not take much for all other potential buyers to stay away given the magnitude of supply that can potentially hit the markets. Other sovereign holders of US debt might join in, either as a means to retaliate against current US trade policies or simply out of fear of being caught out with massive loads of paper that could be declining in value.
Probable Fiscal And Monetary Response
Based on the actions of the Federal Reserve we have seen lately, it seems that there is some level of discomfort with the current size of the balance sheet it amassed over the past decade or so, which is why it feels the need to start slowly unloading some of the treasury bills pile back into the market. In the event that we will be facing a situation where US government bonds will be seen as being out of favor with investors, due in large part because of the on-going threat of massive sales by the likes of China and other sovereign holders of US debt, it is thought that the Federal Reserve could just come in and act as a buyer of last resort. I am personally not entirely convinced that it could safely do that this time around. For instance, if the tariffs will have the effect of causing inflation, dumping more money into the system could be potentially dangerous. The Federal Reserve managed to engage in massive QE the last time around because the environment was stubbornly deflationary.
If the Federal Reserve will not be able to absorb the surplus government debt being pushed on to the market, the only option is to try to stem the surplus, meaning that fiscal policy would have to be massively readjusted. Given the already massive size of the deficit, which would only get larger in the event of an economic slowdown, it would have to take the shape of tax hikes as well as spending cuts. In other words, it could potentially look similar to the Greek tragedy starting in 2010, where austerity created the need for more austerity, due to the negative effects that austerity had on growth and therefore government revenue. This situation could go on for as long as China and others sell US bonds, which could be a process that could last for years before they would run out of ammunition. In the event that monetary policy will not be able to deal with this potential bond crisis, fiscal policy would be very ineffective, even though the government will most likely try to reduce the bond supply. All hope, therefore, rests with the Federal Reserve in the event that the trade war continues to escalate to the point where China and others decide to start selling US bonds.
The Market Solution
In the event that the Federal Reserve will not be able to deal with this potential bond oversupply crisis, it will be left to the markets to deal with it. What this means is that the oversupply needs to be addressed by offering more enticing terms to investors. This means higher yields, making it worthwhile for investors to buy and hold bonds in the face of higher perceived risk of the bond price declining, in case that there is on-going supply pressure. It's impossible to tell just how high those yields would have to go in order to overcome the negative effects of a trade war, which might trigger a massive US bond selloff as a retaliatory measure, but it will most likely have to be substantial if it comes to it. As for the odds of us reaching such a scenario, in my view, it is low still, but it has been growing ever more probable with every blow and counter-blow we are seeing play out in this drama. I think we are now at the point where the danger of it happening can no longer be ignored and investors need to start paying attention.
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.