China's bond sell-off threat: Implications for US economy

Although he previously stated he wouldn't back down, on Wednesday, Donald Trump unexpectedly postponed tariffs on certain countries for 90 days, taking effect immediately. The general 10% tariffs and tariffs on China, which as of Friday remain at 145%, continued. "People were jumping a little bit out of line, they were getting yippy, a little bit afraid," Trump admitted, explaining his decision. He added that he particularly considered the increases in Treasury bond yields.

"The bond market is very tricky, I was watching it. But if you look at it now it’s beautiful. I saw last night where people were getting a little queasy," Trump said. Despite these statements, it is now clear that the bond market is sceptical about long-term economic prospects. Bond investors do not share the enthusiasm observed in stock markets, which saw a sharp rise after the president announced a temporary suspension of tariffs.

The stock indices reacted impressively from Wednesday, rising by up to 10%. Meanwhile, the bond market is notably more reserved in assessing the economic situation. Experts highlight that bond investors are more cautious in forecasting the long-term effects of the current administration's trade policy. They also note that the divergence in reactions between the stock market and the bond market may suggest deeper concerns about the fundamentals of the American economy. Bond investors are often seen as more conservative in risk assessment and less influenced by short-term fluctuations than stock market participants.

It's not that bonds have remained unchanged since Wednesday. The movement in this case is simply much smaller than with stocks. In the morning, the yield on the 10-year Treasury bond fell by 7 basis points to 4.326%, and the yield on the 2-year bond decreased by over 11 basis points to 3.837%. One basis point equals 0.01% – thus showing that the scale of changes is not large.

An especially intriguing aspect of the market reaction is Goldman Sachs's swift change in position. The renowned investment bank withdrew its forecast, which considered a recession in the US next year as its base scenario, just an hour after Trump announced the suspension of new tariffs.

Economists from Goldman Sachs argue that suspending the introduction of new tariffs reduces the risk of an economic slowdown in the upcoming quarters. The bank's analysts highlight that continued trade policy tightening could lead to higher prices for imported goods, translating into increased inflation and decreased consumer purchasing power.

However, despite Goldman Sachs altering its forecasts, the bond market remains cautious. The history of the Trump administration's trade policy shows that the negotiation strategy often involves alternating between tightening and easing positions.

The Wednesday trading session, with its strong increases, clearly depicted the instability in current financial markets. Market experts note that such volatility is typical during times of geopolitical and economic uncertainty. Analysts also indicate that investors remain highly sensitive to any signals regarding trade relations between the USA and China. Both countries are currently imposing increasingly higher tariffs on each other.

Economists remind us that the trade war between the USA and China has been ongoing for several years (initiated by Donald Trump in 2018 during his first term) and has significantly impacted global supply chains and business investment decisions. Some companies have started relocating production from China to other Asian countries, showcasing the long-term consequences of trade tensions.

Investors in bonds, unlike stock market participants, focus on the long-term impact of trade policy on the American economy. Their caution may stem from concerns about lasting changes in the structure of global trade and potential inflationary effects from recurring trade tensions.

Why does the bond market hold such significance for the American economy? Because it can impact ordinary Americans. Other countries – including China – own US mortgage-backed securities worth $1.32 (£1) trillion, representing 15% of the total value of these securities in circulation. A potential sell-off by China could significantly shake the American real estate market.

Moreover, mortgage rates follow the yield on 10-year Treasury bonds. Some analysts speculate that countries holding US bonds and inclined to harm Trump might sell off US Treasury bonds in retaliation for the president's extensive tariff plan.

Guy Cecala, Executive Chairman of Inside Mortgage Finance, points out the seriousness of the situation. "If China wanted to hit us hard, they could unload Treasurys. Is that a threat? Sure it is. They’re going to look at pushing levers and trying to put pressure. ... Targeting housing and mortgage rates is a powerful driver of something like that," he states in a comment.

The main holders of American debt securities include Japan, China, Taiwan, and Canada, and their investment decisions can significantly impact the American mortgage market.

China already began selling part of its American securities last year – by the end of September 2023, its holdings decreased by 9% compared to the previous year, and by December, the decline reached 20%. Japan, which showed an increase in assets in September, started selling them at the beginning of December.

If China and Japan accelerated this sell-off, and other countries followed suit, mortgage interest rates in the USA would rise. Eric Hagen, an analyst in mortgage credit and specialty finance at BTIG, confirms that these concerns are real.

The concern, I think, is on folks’ radar screens, and being raised as a potential source of friction. Most investors are concerned that mortgage spreads would widen in response to either China, Japan or Canada coming in with a retaliatory objective – Hagen assesses in his commentary.

The US real estate market is already facing challenges due to high home prices and weakening consumer confidence. Considering the recent stock market crash, potential buyers are increasingly worried about their savings and jobs.