Why China-Taiwan tensions have risen to the forefront of financial market concerns

It is an island off the coast of China, with an area comparable to that of Maryland and Delaware combined. Its population is about 1 million more than that of Florida.

Often overlooked in global headlines, Taiwan captured the attention of financial markets as the biggest macro risk of the day, prompting many traders and investors to briefly shy away from worries about recession, inflation, banks power stations and Russia’s war against Ukraine. The focus was on US President Nancy Pelosi’s visit to Taiwan, which raised fears of reprisals from the island’s neighboring giant, China.

Earlier on Tuesday, global equities sold off on geopolitical tension as investors rushed to the safety of US Treasuries and traders re-examined their asset positions. After Pelosi’s plane landed safely in Taiwan’s capital Taipei, market sentiment appeared to improve in the stock market, with the S&P 500 and Nasdaq Composite temporarily rising.

“Macro investors are counting on the reopening of China to stabilize their positions,” said Jim Vogel, Memphis-based executive vice president and interest rate strategist at FHN Financial. They reduced allocations to equities and relied on floors for commodity prices, as well as limits on action on lower fixed income prices.

Now, however, relying on China “as an engine of international growth is unreliable, Vogel wrote in a note Tuesday. Moreover, China’s intentions towards Taiwan “have been obvious and threatening for years”, and the narrative between the two “will not go away for years”.

Pelosi is the highest-ranking US politician to visit the island of Taiwan in 25 years, when then-President Newt Gingrich arrived in 1997.

On Tuesday, jitters first surfaced in Asian markets, which were “fragile” in the morning amid fears that Chinese military jets “could buzz Pelosi’s plane,” said Greg Valliere, chief strategist at US policy for AGF Investments. Valliere described the potential for a mistake on either side as “pretty serious”.

Chinese President Xi Jinping is seen by intelligence experts as in need of “entertainment” from his country’s struggling economy and trying to recover from “unusually harsh” COVID restrictions, according to Valliere. At the same time, the Chinese president “cannot afford to look weak” as he seeks a third term later this year.

Meanwhile, Beijing sees Taiwan as a threat, given the island’s healthy economy and individual freedoms. Taiwan is generally considered the most democratic place in East Asia. Pelosi’s visit will have a “major” impact – causing US-China relations to deteriorate further, “with little hope for reconciliation on trade,” the AGF strategist said.

According to Ben Emons, managing director of global macro strategy at Medley Global Advisors in New York. He described the movements in the bond market as being the result of “the Nancy Pelosi affair”.

According to senior analyst Neil Thomas and others of Eurasia Group, a New York-based consulting firm, “Pelosi’s visit will significantly increase US-China tensions, but is unlikely to produce a Chinese reaction. which is likely to cause conflict.

The Eurasia Group sees a “25% chance of a major security crisis, such as a protracted military standoff between the United States and China that threatens further escalation,” they wrote in a note. Still, Beijing could order additional military air and naval drills, could sanction the US delegation and freeze bilateral trade, and has the potential to consider boycotts and sanctions against Taiwan and US companies, the consultancy said.

On Tuesday, the three main US stock indices DJIA,
-1.23%

SPX,
-0.67%

COMP,
-0.16%
finished lower. Meanwhile, investors sold government bonds, pushing yields across the board higher in a reversal from Tuesday’s earlier bond rally.

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