This note was first published to my email subscribers on 1/10/2018.

Early this morning, at 4:26 AM CST to be exact, Bloomberg broke a story that senior officials in the Chinese government are considering reducing or halting purchases of U.S. Treasury Bonds. This caused stock futures to drop, USD to drop, and bond yields to spike (i.e. bond prices to fall) before the open.

So what is this all about and why is it such a big deal?

First, it’s important to understand that China owns about $1.2 trillion of U.S. Treasuries, which represents about 8% of all publicly-owned U.S. federal debt. It’s a significant chunk.

One of the great risks to the dollar, and a potential catalyst for inflation down the road, is if China were to begin dumping Treasuries. China’s purchases of U.S. Treasuries prop up the dollar and suppress interest rates. So if China were to follow through on this threat it could cause a significant drop in the dollar’s value. This, in turn, causes foreign goods to become much more expensive for Americans and, perhaps, altogether unaffordable causing a dramatic reduction in our living standards. This also implies Chinese exports would fall since the U.S. is such a big consumer of Chinese goods. In fact, the U.S. imported $48 billion of goods from China…….in November alone! China is basically vendor-financing our consumption of their goods with this policy.

Combine that inflation risk with the fact that the U.S. economy is already struggling to provide good-paying, “breadwinner” jobs. Much of the jobs currently being created are low-wage, entry-level, part-time service jobs so those folks who are already having a hard time making ends meet would quickly find it even harder as they would get squeezed from both ends (low wages and increased expenses).

Furthermore, less demand for Treasuries (assuming the same or greater supply) would force bond prices down and interest rates higher, which would stress entities and households already laden with too much debt.

So the market’s behavior this morning was a rational response to the news.

Would China really follow through? I don’t know the answer to that. My impression is that it may be difficult for China’s central bank to follow through…at least in the near-term. Dumping U.S. Treasuries would be an act of financial war. Perhaps, it was just a reminder to the U.S. about what they hold over us before we get too cavalier with a trade war. Sidenote: This is why running perpetual deficits is so dangerous both economically and militarily. I’d much prefer the U.S. maintain balanced budgets, very little debt and large reserves so we could control our own destiny without being subject to the whims of other nations. Large debts make any household, business or government fragile and accident-prone and less independent.

An alternative, more sinister explanation, is that China wants to dethrone the dollar, or at least diversify away from the dollar, in which case this morning’s threat would be part of that eventual game plan. China could inflict significant damage to our economy.

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