Since there is no longer any reasonable debate about a trade war having started, let's investigate how it ends.
Two days ago I wrote Trade End Game Scenarios: Boycott Treasuries vs Yuan Devaluation.
I posted the topic following this Tweet by David Rosenberg, Chief Economist & Strategist at Gluskin Sheff.
I strongly disagreed with Rosenberg.
Treasury Boycott Thesis
I am surprised that Rosenberg brings this up because, in my mind, this hash has been settled long ago.
What exactly would China, Japan, and Germany do with their reserves and ongoing trade surplus? Mathematically they have to do something.
Historically, that something has been to buy treasuries. But I suppose China could buy could be gold or US equities. The latter would be smack in the middle of an obvious bubble.
And if China were to dump US treasuries, the alleged nuclear option, it would serve to strengthen the Yuan. Recall that China sold US treasuries to support the Yuan and stop capital flight. In a trade war, China would not want an appreciating currency!
I think Rosenberg proposes nonsense, but given the nonsensical actions of Trump, I cannot rule out nonsensical or illogical responses.
This leads us to the most logical real threat.
Yuan Devaluation Thesis
China cannot retaliate with enough tariffs on its own to combat tariffs imposed by the US. However, the yuan does not float. China could devalue the yuan enough to counteract the value of US tariffs.
But hold on. It is not without risk. Recall that China sold US treasuries to stop capital flight. If China devalues, there is a strong likelihood that capital flight would intensify.
Economist Brad Setser asks What Would Happen if China Started Selling Off Its Treasury Portfolio?
China also could respond asymmetrically, and look toward other levers that it may have over the U.S.
Three stand out:
- Imposing new limits on U.S. firms operating in China, and taking actions that limit their sales in China. Apple and GM sell a lot of made-in-China phones and cars that wouldn’t be impacted by tariffs.
- Weakening China’s currency to offset the drag on China’s economy from far reaching tariffs. A standard, empirically well-grounded, rule of thumb is that a 10% depreciation (against a basket) raises net exports by about 1.5 percentage points of GDP—which could effectively offset realistic estimates of the economic drag of a trade war on China. This option isn’t without risks—it could reignite now contained capital outflows from China, and China might ultimately end up with a bigger-than-initially desired depreciation.
- And the perennial threat that China would sell its Treasuries. That could happen as a byproduct of a decision by China to push its currency down—if China signals that it wants a weaker currency, the market would sell yuan for dollars, and controlling the pace of depreciation would require that China sell reserves. Or could happen even if China maintained its current basket peg and shifted its portfolio around—selling Treasury notes for bills, or selling Treasuries and buying (gulp) Bunds (if it can find them—it might end up buying French bonds instead) or JGBs.
[Mish Comment: I do not fully understand point number 3 given conventional wisdom is that China sold US dollar assets to shore up the yuan and stop capital flight.]
A quick reminder. Treasury rates are usually understood to be a function of the expected path of Federal Reserve short-term policy rates.
Purists (Michael Woodford, for example) argue that “flows” have almost no impact on the Treasury market, and the only thing that really matters is the expected path of the Federal Reserve.
I do, though, think “flows” matter. A standard, empirically well-grounded [PDF] rule of thumb is that 1% of GDP in Federal Reserve “QE” or asset purchases reduces long-term Treasury rates by about 5 basis points, so 10 percent of GDP in "QE" would be expected to reduce the ten year yield by something like -50 basis points (here are the latest projections from Fed staff).
[Mish Comment: Setser believes US Treasury yields would rise by about 30 basis points if China dumped its entire $1.3 trillion portfolio. Yep, that's it. I am more inclined to side with Woodford at least in regards to the flow impact. I do not agree that the "only" thing that matters is the expected path.]
A 30 basis point rise in the ten year, even 60 basis point rise in the ten year, would be painful, but also ultimately bearable. And, critically, these estimates assume that the Fed doesn’t react to a rising term premium and a steepening of the yield curve by easing.
It is fairly easy for the Fed to signal that it expects fewer rate hikes going forward than it expects now. Plus the Fed has a second, fairly direct, way to respond to Chinese sales: change its pace of balance sheet roll off. Roll off is scheduled, counting Agencies, to rise to $150 billion a quarter/$600 billion a year by the fourth quarter. Stopping that, and perhaps signalling that over time the Fed would raise the size of its balance sheet in the long-run would provide a powerful counter to Chinese sales. The combination of a bigger "terminal" Fed balance sheet and a change in rate expectations would, in my view, be more powerful than anything that China could threaten.
I am not in the business of giving China advice on how to upset U.S. markets.
But if the National Security Council ever was convened to discuss China’s options for asymmetric retaliation, I would encourage it to spend most of its time worrying about the consequences of a Chinese exchange rate move. The impact on any such Chinese depreciation on the United States would be limited if the U.S. could convince its allies in Asia to take action to avoid following China's currency down (even though it is against their short-run economic interest; their export driven economies compete directly with China). They have plenty of reserves—and could sell those reserves to absorb market pressure for their currencies to depreciate along with the Chinese yuan. But they aren't likely to do that if they think the U.S. brought on the Chinese devaluation through reckless trade action.
And I would encourage the U.S. government to spend a bit of its time thinking about the impact of Chinese sales of assets other than Treasuries, a scenario that I discussed back in April with Joe Weisenthal and Tracy Alloway.
Treasuries sales in a sense are easy to counter, as the Fed is very comfortable buying and selling Treasuries for its own account. I have often said that the U.S. ultimately holds the high cards here: the Fed is the one actor in the world that can buy more than China can ever sell.
Nuclear Threats Real and Imaginary
The nuclear dumping threat is a topic that just will not go away. Every few months it comes up in one way or another. I was surprised when Rosenberg brought it up.
A reader asked me about dumping the other day. I said what would China buy? Gold? US equities? Copper? What?
Setser asked Bunds? French Bonds? Japanese Bonds?
Not only is dumping a sword the US could easily counteract, it is a sword in which China, without US currency reserves, might chop off its own head.
The real "nuclear" threat is a devaluation. And it would be much harder to counteract. But once again, such an action also poses a huge risk to China. If Chinese investors thought more devaluation were on the horizon, capital flight would intensify.
To stop capital flight, China would have to sell US-denominated assets to buy the yuan, thereby strengthening the yuan.
We have come full circle, haven't we?
Mike "Mish" Shedlock