AUD/USD to Benefit from China Nuclear Option in the Trade War

It’s well known that China is the largest foreign holder of US debt. According to the latest statistics, China owns $1.119 trillions worth of US treasuries. What traders need to understand is that China holds a massive US currency reserve which means that whatever China decides to do with its treasury bond holdings will impact the greenback.  This is especially interesting for those who actively trade the AUD/USD as it is going to create opportunities and moments of significant volatility.

Foreign holders of US Treasury debt as of December 2017.

Foreign holders of US Treasury debt as of December 2017. Source:

Historically, every time there has been a suggestion that China may reduce its US Treasury purchases or halt them all together, the US dollar has weakened. This is not China’s official policy but instead a recommendation of some officials, that China may use its US treasury bonds holdings as a weapon against the USA in the ongoing trade war.

If China delivers on its threats and fires back by selling some of its Treasury bonds, then the greenback could weaken.  Consequently, the risk appetite currencies that have higher interest rates like the Australian Dollar could benefit more. In this scenario, investors will need to generate good yield returns, and the safest way to accomplish this is by parking their money into higher interest-yielding currencies like the AUD.

The economic sanction imposed by the Trump administration on China can turn against the US economy and the US dollar.

The Chinese influence on the global markets is now more prominent because if they wished they reverse course on the US bond purchase, and flood the market with US Treasuries it would force the yields to surge. This policy action could create issues, not just for the US financial system, but it could also lead to a full-scale risk aversion strategy due to the sensitivity of the monetary policy.

Yield Curve Predicts US Recession

Regardless of if the US-China trade war rhetoric escalates further, it seems that the US economy may still be facing headwinds.  The bond market or the bond yield curve is signaling that the US economy will enter into recession in the next 9 to 30 months.

What is the yield curve?

The yield curve is simply a line on a graph that shows the relationship between the price of a loan and the maturity of the loan.  Additionally, it shows the difference between the rates on short-term bonds and the interest rates on the long-term bonds.

Investors and Wall Street analysts like to use the yield curve to forecast the health of the US economy. The yield curve gives traders a view into what investors think it is in store for the US economy, and how heavily they invest in bonds or how much they are compensated for buying them.

Due to the Fed’s aggressive tightening policy, the short-term rates have gone up, while the long-term bonds have failed to rise.  This has created a yield flattering effect. When the yield curve flattens it means that investors are uncertain about what’s going to happen in the future, and this can indicate weakness in growth and lending.

The shrinking gap between the interest rates for the 2 and 10 year bonds.

Source: NY Times

Traders need to be cautious when using the yield curve to forecast the market.   This is because investors are buying these bonds as a reacting to different types of news and analysis they are digesting at a specific moment. In short, they change their minds all the time and this means that the yield curve is constantly moving and what might be true today may change by tomorrow.

A flattening yield curve could help the Australian Dollar as the US Federal Reserve might need to slow down its interest rate rising cycle or completely reverse the tightening cycle if a recession hits the US economy.