What The Trade War Means For The Bond Market

The ramp in trade tensions between the U.S. and China this month wiped $1.1 trillion in value from the S&P 500 in less than two weeks. Stock investors aren’t the only ones rattled by the trade war, as the bond market is also feeling the impact.

Treasury Auction Disappoints

On May 8, the bond market raised a red flag to investors that demand for U.S. Treasuries could drop low enough to create a spike in yields. Bids for the monthly U.S. Treasury auction of 10-year notes exceeded the offering by only 2.17 times, the lowest demand at a monthly auction since 2009, according to Bloomberg.

Ten-year Treasury yields are currently at just 2.4 percent, near their lowest levels of the past year. If demand for Treasury bonds falls, rates could spike quickly.

Experts Raise Concerns

JPMorgan Chase & Co JPM CEO Jamie Dimon is among the market experts watching Treasury demand closely.

“People tend to forecast a little bit of a change, and sometimes it's a huge inflection point which people almost never capture,” Dimon recently said.

Rupert Watson, head of asset allocation at Mercer Investments, said the biggest concern for investors may not be the direct impact of the tariffs.

“The direct effect of the tariffs is pretty small, but the indirect effects may be significant in terms largely of business confidence,” Watson told the Financial Times.

China’s ‘Nuclear Option’

While bond investors mull the possibility of softening demand for U.S. Treasuries, some investors are growing increasingly fearful an escalating trade war could ultimately trigger a worst-case-scenario in the bond market.

China is the single largest holder of U.S. Treasury bonds. If China decides to begin aggressively selling its more than $1.2 trillion in U.S. debt, it could easily tank the U.S. bond market and drive interest rates much higher.

The threat isn’t just hypothetical. This week, Hu Xijin, editor in chief of the state-run Global Times, tweeted that “Chinese scholars are discussing the possibility of dumping US Treasuries and how to do it specifically.”

Fortunately, China will likely only resort to dumping U.S. debt as a last resort. China has already reduced its exposure to U.S. Treasuries by 4 percent in the past year, but flooding the market could potentially do more harm to China’s balance sheet than it does to the U.S.

“It hurts their portfolio. Whether they are willing to endure the pain — I think they might, but not to a great extent,” Kim Rupert, managing director of global fixed income analysis at Action Economics, said this week.

Price Action

Here’s a look at how trade war jitters have impacted the stock market and bond market so far in the month of May:

• SPDR S&P 500 ETF Trust SPY is down 1.5 percent.
• iShares FTSE/Xinhua China 25 Index FXI is down 7 percent.
• iShares Barclays 20+ Yr Treas.Bond TLT is up 1.6 percent.
• iShares iBoxx $ High Yid Corp Bond HYG is down 0.3 percent.
• ProShares VIX Short-Term Futures ETF VIXY is up 5.3 percent.

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