US-China Trade War and the Bond Market

Over the past month, closely observing the rising tensions between the United States and China, one can’t help but sense that something deeper is unfolding, far beyond the surface level drama of tariffs and tweets.

Trump’s trade war with China, characterised by a series of retaliatory tariffs, has driven up import and export prices, ignited inflation, and shaken the global economy. 

Naturally, when trade wars erupt, all eyes turn to the stock markets: headlines scream, volatility spikes, and trillions in equity value vanish.

But here’s the critical question: Is the stock market truly the main battlefield? Or is the real war happening elsewhere, quietly, behind the scenes, in the overlooked bond market?

This is where China’s true counteroffensive lies. While the world watches equities burn, China is executing a more strategic and understated move.

 They are deploying a quiet and often underestimated weapon, one so powerful it threatens to shake the very foundation of US economic power: The bond market.

Why does this matter?

China, renowned as the world’s largest exporter, simultaneously holds one of the largest reserves of US dollars globally. Naturally, excess US dollars require secure, low risk investments, with the safest go to choice historically being US Treasury Bonds, labelled as “Risk-Free” securities.

For over a decade, China parked over a trillion dollars in US debt. Recently, however, China strategically began reducing its holdings, dropping from over one trillion dollars to approximately $700bn in Treasury Bonds. This reduction has repositioned China below the second largest holder of US debt worldwide, yet remains strategically advantageous.

China now leverages this vast debt portfolio as a potent, double edged weapon against Trump’s aggressive policies.

How exactly is this weapon deployed?

China began dumping US Treasury bonds, dramatically increasing their supply in the market. This surge decreases bond prices significantly, spiking Yields upward.

Why does this happen?

Newly issued bonds must now offer higher interest rates to remain competitive. But that’s not the end. As yields spike, older bonds with lower fixed interest rates become less attractive, forcing sellers to sell them at discounts (below par value), which pushes their prices down further in secondary markets.

It is a vicious cycle, intensifying investor uncertainty. 

Faced with heightened uncertainty, investors demand higher risk premiums (returns), escalating borrowing costs for the US government. The Treasury, already burdened with financing a ballooning Federal deficit, is now forced to issue new debt under highly unfavourable terms, making government spending, debt repayment, and financial stability much harder to maintain.

In response to this instability, major credit rating agencies, including Moody’s, downgraded US Treasury bonds from their prestigious Aaa rating to Aa1 on May 16, 2025. Such a downgrade signals serious concerns, as US Treasury bonds have traditionally been regarded as the ultimate safe haven in global finance.

But why is this particularly critical?

The answer lies in the US Dollar. It is not just any currency, it is the world’s reserve currency. It is the unit of account for global trade, especially oil and natural gas, representing trust, power, and financial dominance. When confidence in the dollar begins to erode, the entire world takes notice.

How does this happen practically?

China’s reduced demand for US debt increases the supply of dollars where demand is not met, depreciating the dollar’s value relative to other currencies.

At first glance, this might seem following President Trump’s plan. A weaker dollar theoretically increases exports by making them cheaper globally.

However, the negative consequences far outweigh these potential gains.

A weaker dollar makes imports more expensive, fuelling inflation domestically.

 More critically, it erodes global confidence in the currency. If the world doubts the dollar’s stability, they will gradually but inevitably shift to alternative currencies.

 That is how capital flight starts, and that is how the financial account, the silent offset to America’s chronic trade deficit, begins to collapse.

Let’s not overlook this fact: the US persistently runs a trade deficit but survives because foreigners willingly finance that deficit by investing in US bonds. If this confidence disappears, the US economy loses the very foundation it has depended upon for decades.

Rising borrowing costs and a harder to finance deficit mean America must offer even higher returns to attract hesitant investors. Yet, higher returns alone do not restore trust.

So, what do we see unfolding in real time?

Treasury bond auctions with underwhelming demand, despite offering higher returns. For instance, on May 21, the US Treasury’s auction of $16bn in 20-year bonds saw notably weak demand. The bonds were sold at a yield of 5.047%, a substantial increase compared to the 4.613 percent average in prior auctions.

This surge in yield reflected heightened risk perception, as investors demanded greater compensation amid concerns over fiscal policy and rising debt levels. Why? Because the assumption of the US debt as “Risk-Free” is cracking, and once broken, rebuilding that confidence is difficult.

Trump, sensing this danger, began shifting strategy. He scaled back tariffs, signalling desperation to re-engage China. Most importantly, the part often missed. He didn’t just backtrack on some tariffs.

Trump reached out to the petro-dollar plan. The Gulf region: Trillions of dollars began flowing into the US from Gulf states, particularly through sovereign wealth funds, alongside with other investments.

Why?

Trump recognised clearly that without trust in the dollar, cheap debt evaporates, threatening the stability of the US fiscal system. US Treasury bonds are more than just debt instruments, they are crucial tools for global liquidity, essential for the worldwide financial system’s smooth operation.

Thus, the threat extends beyond rising US debt, as weakening global trust in the dollar poses an existential risk to US economic stability. By securing massive financial support from the Gulf, Trump attempts to reassure global markets: The world still trusts the dollar.

But is this move from strength or from desperation?

On the other hand, China, does not escape unharmed. A weaker dollar means a stronger yuan, bad news for Chinese exporters, and their massive dollar reserves lose value. 

But here’s the critical difference: China’s pain is manageable, while America’s suffering could undo mechanisms sustaining its long held financial dominance.

Zooming out momentarily, trade relationships ideally offer mutual benefits, though these benefits differ. 

The US relies on its financial dominance, cheap debt, and global dollar confidence, while China leverages its manufacturing scale, cost efficiency, and large workforce.

Tariffs used as a tool of war, upset this delicate balance. They introduce uncertainty, shift incentives, and threaten the structure that sustains mutual economic benefit. Coupled with monetary tightening from the Federal Reserve and limited fiscal support from Congress, this creates a formula for slowed growth, rising costs, and pervasive uncertainty.

So, we return to the critical question: Is this confrontation truly about tariffs?

Trust and confidence, once lost, is challenging to rebuild. Without trust and confidence, the dollar and everything it supports stands precariously on shaky ground.