The U.S. and China vow to dig in their heels as simmering trade tensions between the two countries risk boiling over into an all-out trade war. Kim Parlee speaks with Scott Colbourne, Managing Director at TD Asset Management about the potential economic impact of tit-for-tat tariffs and what that could mean for the Treasury market.
- Welcome to the show. It's great to have you with us. I'm Kim Parlee. As you just heard, the ongoing trade tussle between the US and China has been fueling waves of volatility in these markets, in part because of all the uncertainty it's creating. And that uncertainty is also being felt in the Treasury market. China is one of the biggest holders of US debt. And if Beijing were to start selling that debt off, some say you could see a sharp rise in yields.
Here with more to give us some more context is Scott Colburn. He is Managing Director at TD Asset Management. Good to see you. We got a nice, juicy topic to jump on tonight.
So I said in the intro that if China decided it wanted to sell Treasuries, here it would happen. Can you just, first off, just give us all the background on this? How much do they own? And then step by step, what would actually happen?
- OK, China owns about just over a trillion dollars in US Treasuries. Globally, $22 trillion in US Treasuries out there. So just under 5% of all Treasuries. And like all central banks, they own these Treasuries to manage their reserves.
KIM PARLEE: Now, I'm going to say, someone would say 5%, that doesn't sound like a lot. But it is when you-- how?
- But it is, and you're the marginal buyer, right? So an influence of a large player that owns a lot of the assets-- any asset-- and they decide to dump, and the terminology that everybody's using right now would have profound impact. Certainly, rates would go back up. And that would spill over into the behavior of other participants in the market. They would have to step in to fill the void and buy those treasuries at a higher yield. So that would have an implication for the government bond markets, credit markets, the mortgage market. It has a spillover impact, for sure.
- Tell me-- so OK, we'll talk about the likelihood of this happening in a second. So we'll just kind of paint the scenario first. So when you say it impacts the credit markets, how? Give me an example. Like mortgages, let's say, I mean, what happens to somebody's mortgage in the States when this happens?
- There's estimates that you could see rates go up by-- 10-year rates up by about 50 to 75 basis points if overnight, China just dumped all their US Treasuries. And so that would feed into the funding of banks who raised their mortgage rates in response to higher government Treasury rates. So mortgage rates would go up. The cost of corporate debt-- high yield debt-- would suffer. Risk assets would suffer in this environment. It certainly would be unsettling and cause a period of risk off in the market.
- And what would happen on the other side of the transaction? So if China said hey, we're selling off this, they get a boatload of money.
- Then what do they do with it?
- Yeah, what do they do?
- Right. I mean, that's the big issue is-- and why some people are downplaying this as a likelihood. You sell all year Treasuries, you get US dollars. Then what do you do with it? What else can you buy? Well, there's no other big bond market to buy. Certainly, you could convert those US dollars back into Chinese yuan, but that would put an-- it would be an appreciation on the yuan. Well, in this environment, when you have a trade war, you're probably wanting a weaker currency to accommodate the impact of the tariffs, rather than a stronger currency. So I think that's the strongest argument here, that it's unlikely.
- It's a low probability.
- A low probability event but certainly would be a high impact event if it happened.
- Now, it does though look as though-- if you kind of look at the levels of how things are escalating, more tariffs are going in place. Tonight or today, an executive order was signed to start maybe a Huawei not allowing that purchase. And then the next step would be maybe Treasuries, one could say. It is escalating, though.
- Absolutely. There's sort of like two games, here, two narratives in the market. There's the long game that people are talking about. This is the new Cold War, and this tension will be in the background. It will rise. And it's going to profoundly shape both powers going forward.
And then there's a sort of a shorter term narrative, which is are we going to be able to get a trade deal done into the G20 event in June? And the optimists look for that as the catalyst. And so ratchet up the tension into that event, get a good deal, exit, lift the stock market, and that's the optimists' take on things right now.
- The other thing, of course, affecting the market is not just this but a few tweets coming up from a few people. And the US president tweeted this. "China will be pumping money into their system and probably reducing interest rates as always in order to make up for the business they are and will be losing. If the Fed ever did a match, it would be game over. We win. In any event, China wants a deal."
OK, lots of rhetoric there. But let me ask you about the president. What does the Fed do with all of this? I mean, obviously, he's quite overt. He's telling the Fed what he wants them to do. But at the same time, though, the Fed is going to be dealing with some very different economic circumstances when this comes in. So they may do what he wants, not because of what he's asking, because they need to.
- Yeah, I think on the one hand, what Trump is doing in public is what a lot of presidents have done in private. They've had their meetings with the Fed governors, and they've expressed their displeasure. So Trump is just open, using the tweets to tell everybody what he thinks.
So I think from that point of view, the Fed is used to this pressure and will continue. I think going forward, though, on balance, Trump's been right. He didn't want them to raise rates in December, and it turns out that we sort of backpedaled from that hike. So I think you're seeing in a market now, with the market's priced in a cut, effectively. And now with the trade tensions, it's going Trump's way in a way that we're going to likely see of a cut over the course of the next year in the Fed.
- I know that you were talking to my producer earlier about the last Fed conference back in November, and lots was being talked about. Pretty wonky for, I think, the rest of us who are trying to say-- but there's some things we should be paying attention to. And what were those?
- Yeah, so there's a Chicago Fed conference. Last November, the Fed decided to examine all its tools for monetary policy. And as you say very well, it's wonkish. But one of the outcomes here, and what some of the Fed governors have talked about is the possibility of looking at, rather than targeting inflation, PCE core deflator inflation at 2%, we're looking at it on an average basis over time. And then if you look at that figure for the past 17 years, basically, core PCE has been below 2%.
So in essence, you're looking to target average inflation over time closer to 2%. So if you've under-shot, well, then you're going to let inflation run hot as a consequence, have easier monetary policy, and raises the likelihood that this is sort of socializing us to a new behavior function out of the Fed, that maybe going forward, there's a likelihood that, even with inflation close to target, that--
- They're not going to move.
- --because it's on average, they may even cut.
- What are you looking for right now in terms of-- you're saying you could cut. I mean, I think the market's pricing in maybe a cut in the next little while. More than one? Do you see? What do you kind of-- what it's going to depend on, I should ask.
- I mean, you step back, you look around the world. And the trade tensions have ratcheted things up. You've had New Zealand, India, Malaysia all cut rates. You've got-- maybe the Bank of Canada is the only one on hold. But Australia, New Zealand again, India again, the US, all biased to cutting over the course of the next year. Trade wars and trade tensions, it's leading to slower growth. Low inflation, inflation continues to undershoot. So you may see this likelihood that you'll see more cuts over the course of the next year.
KIM PARLEE: Fascinating conversation. Will you come back?