Financial nuke or dud?

There are dire warnings about a financial nuclear option in the dawning US-China trade war:

It took China just 11 hours to retaliate against the United States for proposing tariffs on some 1,300 Chinese products, but Chinese officials are holding back on taking aim at their largest American import: government debt.

In a tit-for-tat response to the Trump administration’s plan for 25 percent duties on $50 billion of Chinese imports, China hit back with its own list of similar duties on key American imports including soybeans, planes, cars, beef and chemicals. But officials signaled no interest for now in bringing their vast holdings of U.S. Treasuries to the fight.

China held around $1.17 trillion of Treasuries as of the end of January, making it the largest of America’s foreign creditors and the No. 2 overall owner of U.S. government bonds after the Federal Reserve. Any move by China to chop its Treasury portfolio could inflict significant harm on U.S. finances and global investors, driving bond yields higher and making it more costly to finance the federal government.

But a reader explains why the bond threat is toothless.

It’s hilarious reading Drudge headlines about how the Chinese owning US Treasuries is some kind of “nuclear option” for Beijing.

Presumably, China thinks it will somehow crash the value of its Treasury holdings by dumping it on the open market. This is somehow supposed to destroy the value of these bonds…or something. It’s almost as if no one understands how bonds actually work.

Bonds have an intrinsic value, the face value of the bonds which is the amount of money that is returned to bondholders when the bond matures.

This is the par value. If I sell a bond to you for $1,000, then I am obligated to return $1,000 to you plus interest when the bond matures. If I sell a $1,000 bond to you at an interest rate that is lower than the market rate, then I may only collect, say, $950 for the bond, but, at maturity, I am obligated to pay $1,000 back to you plus interest.

If you decide to sell the bond that I sold to you on the open market, then you may get a premium above the $1,000 or you may get a discount below $1,000, but the face value of the bond, the money owed, does not change. Upon maturity, $1,000 is owed to the bond holder.

The value of the bond may oscillate on the secondary market because of the risk of default or because interest rates have changed, but, absent the risk of default, the value of the bond is purely mathematical. Since US Treasuries have virtually zero risk of default, the value of the bond is simply the interest rate paid by the bond, vs. the interest rate of competing securities of similar risk vs. the duration. These can all be calculated in Excel using amortization tables.

There is nothing China can do to devalue US Treasuries by dumping their holdings. If they decide to sell for an artificially low price, then they are simply creating arbitrage opportunities for the buyers and frenzied trading will quickly bid back up the value of those bonds to their mathematically determined price.

See how important bonds and interest rates are in understanding the economy?

The financial trade media is heavily invested in arguing that there can be no winners in a trade war. But they are ignoring the fact that the trade war has been ongoing for decades and the USA has been continually surrendering.

They are also ignoring the uncomfortable fact that if comparative advantage were legitimate, the correct response to tariffs and other trade restrictions would be to do nothing. According to free trade theory, a country is economically better off if it enacts no trade restrictions regardless of what its trade partners do. The fact that various US trade partners are threatening retaliation for US tariffs is further evidence that, despite their free trade rhetoric, they do not genuinely believe in the concept. Nor should they, because it does not work as advertised.