Why Financial Markets Worry About US-China Trade Dispute

The growing US trade dispute with China—a major trading partner and buyer of American assets—could pose a significant threat both to US markets and the economic recovery, analysts say.

Photo by: Cory Doctorow

A prolonged economic battle between the two countries could hurt both US companies that depend on Chinese trade and drive down prices of Treasurys if China decides to stop buying US debt.

The dispute erupted Friday night when President Obama announced a 35 percent tariff on Chinese tires, apparently in response to demands from organized labor leaders who said the imports were hurting American jobs.

In retaliation, China said it would take action against automobile and chicken imports from the US.

Global stock markets were rattled Monday by the escalating dispute, though the losses were fairly narrow. Still, analysts say the issue could blow up and threaten the investment climate around the world.

"Everybody has to have cooler heads here and realize that an all-out trade war is not going to be good for anybody," says Rob Lutts, CIO and president at Cabot Money Management in Salem, Mass. "Everyone's a loser in that situation."

It's not just equity markets that could get hit. The bond market, particularly in government-issued debt, relies heavily on Chinese involvement.

China, in fact, is the largest buyer of US Treasurys with nearly $800 billion in holdings and is a regular participant in the debt auctions so critical to finance the deficit spending, bailout and stimulus programs ongoing from Washington. The Chinese hold about 25 percent of all US debt.

While there was disagreement over how serious the latest rift is, some bond experts were concerned.

"There is too much discussion of why this is no big deal," Kevin Ferry, of Cronus Futures Management, wrote in an analysis. "That type of thinking avoids the condemning of the action as foolish and wrong-headed at the top."

Ferry said Chinese auto retaliation represents a serious threat to the US auto industry, which has shown signs of life lately due in some part to the government's Cash for Clunkers program.

But he worries about the larger threat posed to the US debt market.

"Today, a boatload of virtually interest free T-bills goes on the block," Ferry said. "Forget the poultry, if I'm the Chinese I sit this one out."

There's also worry that Obama's move could be seen negatively not only in China but also the rest of the trading world.

"The Chinese don't have a lot of respect for Obama, and this even deepens that disrespect because it's offensive to them," says Tony Sagami, editor of Weiss Research's "Uncommon Wisdom Daily" newsletter. "There's no claim of wrongdoing. The only claim is it hurts the US tire industry.

"You could say that about any low-cost competitive industry. That means this could expand on almost any foreign competitor."

As for the immediate impact on stocks, the effect appears to be muted at least until the World Trade Organization gets involved and arbitrates the dispute. Wall Street opened lower in trading widely attributed to China tensions, but the market soon leveled out and was relatively flat in afternoon trading.

The WTO may well overturn the Obama trade move, says David Resler, chief economist at Nomura Securities International in New York, which ultimately could be an effort to appease union leaders and get overturned anyway. Obama is counting on labor to help him with his effort to get health reform passed.

"It could be a huge setback, but it depends on what comes next and I don't know what comes next," Resler says. "It needlessly exposes us to risk."

At its worst, the move toward punitive tariffs conjures up images of the Smoot-Hawley Act, passed in 1930 after the previous year's stock market crash. The act, which imposed tariffs on more than 20,000 goods and invited mass retaliation abroad, is seen by some historians as helping worsen the Great Depression.

Investment advisors are hoping cooler heads prevail before a full-blown trade war comes to pass.

"We don't know how far they're going to walk down this road," Lutts says. "Both sides recognize let's not kill the goose that's laying the golden egg here—that's both countries having a very healthy trading relationship."