The increase in equity market volatility preceded the escalation of trade tensions, but now the latter appears to be stymieing attempts to stabilize the former. The equity market was its own dynamics, and last year’s low volatility was an anomaly and payback, as in reversion to mean, is painful.  

Following the list of the specific Chinese goods that would hit with US tariffs for the intellectual property rights violation claims and the list of US goods, China would target, the S&P 500 posted a reversal pattern in the middle of the week. It traded on both sides of the previous day’s range and then closed above the previous day’s high. There was follow-through buying on Thursday, but Trump threat to double down by instructing the US Trade Representative to identify an additional $100 billion of Chinese goods to slap an additional levy threatened fresh escalation and saw stocks unwind their gains.  

Some observers are keen to point out that there are not another $100 billion of US goods imports that China can put a tariff on to match the escalation. But they do not seem to know what to do with that observation. Surely it does not mean game over. They seem confused. Do they hold Chinese officials in such low regard as to assume they can only see the next step? Isn’t it the US that is accused of short-termism compared to China’s long-game?  

There are many other areas that China can demonstrate its displeasure. Many observers jump to the selling US Treasuries or to depreciate the yuan. However, for numerous reasons these are non-starters, and we encourage investors and policymakers to be content with such answers, and we prepared for other responses.  

A decline in China’s Treasury holdings may not send a clear signal as it takes a while to detect, may not have much impact, and could distract from China’s own reserve and currency strategy.  When China’s Treasury holding fell by $200 billion over a six-month period in 2016,the impact on US yields was not perceptible. China’s actions could simply be lost in the deepest and most liquid market in the world.  

Nothing fails like success. If China broadcast its intentions to sell US Treasuries, it would undermine the value of its substantial portfolio, if it were successful. Also if it were successful in driving up US interest rates, and weakening the US economy, it would be cutting its nose to spite its face as it would undermine its single largest customer. China would also have to redeploy the capital it takes out of the US Treasury market. It would give up significant yield and liquidity to go into German, French, and Japanese bonds. Many talk about a shortage of German paper given the private sector and ECB demand. 

Similarly, many pundits emphasize the risk that China could devalue its currency to offset in whole or in part the effect of US tariff. It is cited as a threat. This too would seem to require a change in China’s strategic decisions about the yuan and macroeconomy. Moreover, in recent months, the only major country to appear to talk down its currency is the United States. It was sufficiently salient that it was also discussed at length at the ECB meeting in February. To be sure, the US quickly walked back like a child who trespassed might.