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Bond Yields Climbing: Could the Chinese Weaponize US Debt?

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Yields have been on the rise this week in the midst of a bond market sell-off.

Two-year borrowing costs hit their highest level in a decade Wednesday. The yield on the 2-year Treasury climbed to 2.816%. Meanwhile, the 10-year Treasury yield hit a four-month high of 3.07%.

What’s going on here?

The most obvious reason for falling bond prices and rising yields is the enormous number of debt the US Treasury is currently dumping on the market. Despite the “strong economy,” the US government is borrowing money like it’s in the midst of a deep recession. To cover the growing federal deficit, the Treasury Department announced earlier this summer that it would raise  $329 billion through credit markets during the July-September period. The borrowing estimate for the third quarter ranked as the highest since the same period in 2010 – at the height of the Great Recession. It comes in as the fourth-largest level of borrowing on record for the July-September quarter.

But there could be another reason for the recent bond sell-off — the ongoing trade war. There is some fear the Chinese could weaponize their massive holdings of US debt and use it to gain the upper hand in the escalating tariff battle.

This week, Pres. Trump announced a 10% tariff on another $200 billion in Chinese imports. The Chinese retaliated, levying tariffs on $60 billion in US products.

You’ll notice that the Chinese are starting to have a difficult time keeping up with this tariff tit-for-tat. Could it use its huge holdings of US debt as a weapon in the trade war? Some analysts think it could.

The Chinese aren’t currently dumping US debt, but they aren’t buying either. China’s holdings of US Treasuries have fallen slightly over the last several months, hitting a six-month low of $1.17 trillion in July.

But some analysts say the Chinese could start aggressively selling Treasuries on the market in order to boost US borrowing cost as they run out of tariff raising options. A MarketWatch report verbalized this fear.

Some investors fear China will use other means than tariffs to retaliate against the US, with some suggesting the second largest economy could sell its Treasury holdings to push the US’s borrowing costs higher.”

Weaponizing US debt is the ace up China’s sleeve.

The Chinese can’t out-tariff Trump. The US imports far more products than the Chinese. In other words, there is a lot more stuff coming into the US from China than vice versa. But that $1.17 trillion in Treasury holding does give the Chinese some leverage. China holds more US debt than any other country. If it started dumping all of the debt on the market, interest rates would soar and the dollar would plunge. This is not a good scenario for an economy built on piles of debt.

A lot of pundits call this a nuclear option. It would be a disaster for the US economy. But it also comes with a significant amount of risk for the Chinese. A fire sale on Treasuries would cut into Chinese reserves and potentially destabilize the yuan. But China wouldn’t have to sell everything to have a huge impact on US interest rates. Even dumping a relatively small percentage of its holdings would push rates up, and the debt-fueled US economy has very little tolerance for higher interest rates. Just consider the enormous federal debt the US Treasury is trying to finance. Last month, the US government set a spending record. Add to that piles of personal and corporate debt.

Will the Chinese really weaponize US debt and use it for leverage in the trade war? It could. Regardless, interest rates are climbing even without the Chinese aggressively selling Treasuries. This rising interest rate environment should concern investors. It means the easy-money party is likely coming to an end.

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