Why China-Taiwan tensions moved to the forefront of financial market worries

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

Often overlooked in world headlines, Taiwan is grabbing the financial market’s attention as the biggest macro risk of the day, prompting many traders and investors to turn away from concern about recession, inflation, central banks and Russia’s war on Ukraine. The focus is on US Speaker Nancy Pelosi’s visit to Taiwan, which is triggering fears of retaliation by the island’s giant neighbor China.

Earlier on Tuesday, global stocks sold off on the geopolitical tension, while investors scrambled to the safety of US Treasurys and traders took a second look at their positions across assets. After Pelosi’s plane landed safely in Taipei, Taiwan’s capital, market sentiment seemed to improve in the stock market, with the S&P 500 index and Nasdaq Composite popping higher.

“Macro investors have been counting on China’s reopening to stabilize positions,” said Jim Vogel, a Memphis-based executive vice president and interest-rate strategist at FHN Financial. They’ve pared allocations to equities and have been counting on floors for commodity prices, as well as limits to downside price action in fixed income.

Now, however, relying on China “as an international growth driver is unreliable,” Vogel wrote in a note Tuesday. What’s more, China’s intentions toward 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 American politician to visit the island of Taiwan in 25 years, when then-Speaker Newt Gingrich arrived in 1997.

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

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

Meanwhile, Beijing sees Taiwan as a threat, given the island’s healthy economy and personal freedoms. Taiwan is generally regarded as the most democratic place in East Asia. Pelosi’s visit will have a “major” impact — resulting in further deterioration of relations between the US and China, “with little hope for a reconciliation on trade,” the AGF strategist said.

Frantic traders had been tracking every move of Pelosi’s plane on popular flight trackers, and it was flight-to-safety sentiment that drove bond yields lower earlier on Tuesday, according to Ben Emons, managing director of global macro strategy at Medley Global Advisors in New York. He described the bond market’s moves as being the result of “the Nancy Pelosi kerfuffle.”

to senior analyst Neil Thomas and others at Eurasia Group, a New York-based consulting firm, “Pelosi’s visit will significantly raise US-China tensions but is likely according to produce a Chinese reaction that risks conflict.”

Eurasia Group sees “a 25% chance of a major security crisis, such as a prolonged US-China military standoff that threatens further escalation,” they wrote in a note. Still, Beijing could order additional military air and naval exercises, might sanction the US delegation and freeze bilateral exchanges, and has the potential to consider boycotts and sanctions on Taiwan and US firms, the consultancy said.

On Tuesday, major US stock indexes DJIA,
-0.58%

SPX,
-0.01%

COMP,
+0.40%
were mixed in late morning trading. Meanwhile, investors sold off government bonds, sending higher yields across the board in a reversal of Tuesday’s earlier bond rally.