China: We have powerful reserves... You're going to regret this

China believes their reserves are now the ultimate power in the universe, and some are suggesting they use them.

According to this story, China is threatening to use its huge dollar reserves as a weapon to counteract protectionist rhetoric from Congress. This was given as a reason for the sell-off in Treasuries today.

I've written on the Asia effect on rates before.

http://accruedint.blogspot.com/2007/01/tanned-rested-and-ready.html
http://accruedint.blogspot.com/2007/05/spreads-and-china.html http://accruedint.blogspot.com/2007/06/capitulate-or-die.html

The Telegraph story calls this the "nuclear" option. I think that term is apt. There are several parallels to launching a nuclear attack.

1) Both will cause devastating damage to the target nation.
2) There will be repercussions for the attacker, e.g., political, economic etc.
3) Nations tend to use threats like this as leverage, perhaps never intending to use them.

What would happen if China tried to crush the dollar? First of all, U.S. interest rates would rise substantially. U.S. consumers would have less purchasing power, both because financing would be expensive and because foreign goods would become pricier. As a major exporter to the U.S., a weaker U.S. consumer would not be in China's best interests.

I think the unwinding of the flight to quality has a lot more to do with today's Treasury sell-off. I know the auction didn't go so well, and some people were claiming that was China-related. But with spread product ripping tighter, and the Fed sounding pretty damn hawkish, rates are still too low.