'A shot in the foot': The fallout from a trade war could make one of the market's biggest fears even worse
- President Donald Trump is expected to announced new tariffs on China worth roughly $50 billion.
- Bank of America Merrill Lynch says this escalation of the global trade situation could exacerbate one of the market's biggest fears.
As President Donald Trump prepares to officially announce roughly $50 billion of tariffs on Chinese exports, traders everywhere are scrambling to assess the market impact and position accordingly.
Among the biggest worries for investors is the US 10-year Treasury yield, which market experts say is on a worrisome ascent higher. Not only do higher yields put pressure on stocks by making them less attractive compared to fixed income, they also exacerbate fears that US government bonds are slipping into a bear market.
If those are the types of issues that keep you up at night, Bank of America Merrill Lynch has bad news for you.
The firm's rates strategy team says a "slow unwind of globalization" means yields will move higher in the medium- to long-term. The crux of BAML's argument is that the Treasury market has received major support from foreign investors over the past 20 years, and any threat to that backstop could have a destabilizing effect.
As the chart below shows, foreign investors have accumulated about $6 trillion in Treasurys over the past two decades - roughly 40% of the market - through trade and intervention, according to BAML data.
"A meaningful slowdown in global trade may result in less FX reserve accumulation globally, reducing the need to buy US Treasurys," a group of BAML strategists led by Carol Zhang wrote in a client note. "This may be a shot in the foot for the US just as the US expanded the fiscal deficit and is in need of sponsorship for the new debt."
These developments are also impacting other asset classes, such as equities. For weeks, Wall Street has been expressing concern over how higher yields will impact stocks. Some have even gone as far as to single out the 3% level for the 10-year as a reckoning point for equities - and at 2.82% on Thursday, we're close.
And as if traders didn't have enough to worry about, the Federal Reserve reiterated on Wednesday its commitment to hiking interest rates at least twice more in 2018. That sort of monetary tightening is something that's historically boosted Treasury yields and spurred stock weakness.
With all of this in mind, how should investors be positioned? BAML says the best bet is to be short Treasurys, and by extension long Treasury yields. Even though it's already quite a popular trade, BAML stresses it's not yet time to throw in the towel.
"We do not think it is time to give up shorting Treasuries," said Zhang.