China and Japan’s Nuclear Option in the Pending Trade War

China, Japan and some other countries have a nuclear option they could use in the pending trade war.

If deployed, it could serve as the pin that pops the stock market bubble. At the same time, it could put the US government in a nasty spot as it tries to fund its profligate spending and upward spiraling debt.

What is this nuclear option?

US trade partners could dump US Treasuries.

Last week, Pres. Trump announced significant tariffs on steel and aluminum, imports. The president said duties of 25% on steel and 10% on aluminum could be formally announced this week. From there, the rhetoric heated up.

Over the weekend, Trump threatened European automakers with an import tax on autos if the EU retaliates against his steel and aluminum tariffs. China said it would “defend its interests.” Canada said it would retaliate if the US follows through on its metal tariffs.  This is significant given that Canada ranks as the number one exporter of steel to the US.

Trump said a trade-war is “easy to win.” In his podcast last week, Peter Schiff took issue with that notion and explained just how unlikely it is that the US will actually win anything by raising tariffs.

Most of the focus has been on what kind of retaliatory tariffs US trade partners will levy if Trump follows through. But Reuters picked up on another weapon US trade partners have in their arsenals. If deployed it could wreak significant havoc on the entire US economy. They could dump US Treasuries at a time the US desperately needs more demand for its debt – not less.

Should China, Japan and other nations, which have recycled their trade dollars through their Treasuries holdings, suddenly decide to whittle them down, markets could be in for a rough ride. Such a retaliatory move, in the wake of Trump’s first big protectionist action, comes at a time when foreign demand for U.S. debt is seen critical to offset an expected surge in federal borrowing needs, analysts and investors said on Friday.”

We’ve already asked the question: who is going to buy all of the Treasuries the government needs to sell in order to fund its massive deficit?

The US Treasury Department reportedly plans to auction off around $1.4 trillion in Treasuries this year, and the department expects that pace of borrowing to continue over the next several years.

The US government depends heavily on three major buyers to finance its debt – China, Japan and the Federal Reserve.

And all of them are pretty much already out of the market right now.

China was taking about slowing or even stopping its purchase of US Treasuries in January – before the president started talking trade war. The Fed is all about shrinking its balance sheet and raising interest rates. That means not only is it not buying Treasuries, it’s not rolling over the bonds it already holds. The government will have to sell bonds to somebody else in order to pay off the Fed. And in mid-February, Bloomberg reported rising currency hedging costs and the surge in short-term bond yields are “driving Japanese money managers away from Treasuries.” Instead of buying US debt, the Japanse are turning toward Europe.

So when it comes to Treasuries, nobody was really in a buying mood to begin with. With a trade war on the horizon, China, Japan, and others could even go a step further and start dumping US debt on the market. That means bond prices will tank even faster and yields will increase.

That’s not good news.

Especially considering China and Japan rank as the top foreign holders of US Treasuries. According to US Treasury Department data, as of December, the two countries held a combined $2.25 trillion in US debt. All told, foreign governments own more than $4 trillion worth of US Treasuries.

As Reuters pointed out, typically when yields go up, stock prices fall. Treasury yields are also used by banks and other lenders to determine what they charge consumers on mortgages and other loans. So, average Americans carrying record levels of debt will also feel the squeeze.

In other words, rising bond yields could pop both the stock market bubble and the massive US debt bubble. The Sovereign Man summed up the implications of rising bond prices in an article last month.

Make no mistake: higher interest rates will have an enormous impact on just about EVERYTHING. Many major asset prices tend to fall when interest rates rise. Rising rates mean that it costs more money for companies to borrow, reducing their leverage and overall profitability. So stock prices typically fall. It’s also important to note that, over the last several years when interest rates were basically ZERO, companies borrowed vast sums of money at almost no cost to buy back their own stock. They were essentially using record low interest rates to artificially inflate their share prices. Those days are rapidly coming to an end.”

Rising bond yields were a concern even before talk of a trade war. Former Reagan Office of Budget and Management director David Stockman said in a Feb. 27 column he thinks that a bond market ‘yield shock’ will be the crash-trigger this time around and for a self-evident reason.

The central banks of the world have unleashed a credit monster—-$67 trillion in the US, $40 trillion or more in China and $230 trillion on a global basis—and know they must finally stop the relentless monetization of existing debt and other assets.”

If China, Japan and other countries do turn to the nuclear option in the pending trade war, it will only exacerbate an untenable situation and hasten a crash. It will push bond yields higher faster. That’s something the markets simply cannot handle.

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