China Will Soon Be Able To Close Off The Straits Of Hormuz And The Red Sea

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by Tyler Durden
Wednesday, Aug 05, 2020 - 11:48 AM

By Michael Every of Rabobank

The world is rightly shocked today by the terrible explosion that devastated Beirut, and our thoughts go out to the people of Lebanon. The cause is still unknown, but visual evidence and official government statements suggest it was a tragic accident due to storing fireworks next to up to 2,750 tons(!) of ammonium nitrate. Despite denials from daggers-drawn Israel and Hezbollah, even a region rife in conspiracy theories had dismissed thoughts of this being either (Lebanese) politics or regional geopolitics (indeed, Israel has offered medical assistance given Beirut’s hospitals are overflowing)…until US President Trump blurted out his generals had told him it looked like a bomb and “attack” of some kind. Speculation or confidential information? Either way, it’s explosive.

As is the fact that not too far away, the United Arab Emirates has opened its first nuclear reactor, a step to being able to develop a nuclear weapon if it so chooses – though it has sworn not to. Not so sworn, perhaps, is Saudi Arabia. The Wall Street Journal reports China has helped Riyadh construct a facility for extracting uranium ‘yellowcake’ from uranium ore, a crucial step to developing nukes. It’s ironic given China has signed a 25-year co-operation agreement with the Saudis’ bitter foe Iran, including military cooperation, and Tehran is itself not far from a nuclear breakout capability. It’s also tragic if this leads to greater regional instability – which has serious implications for energy prices we saw just a flicker of yesterday. It’s also a further indication that China and Russia are stepping into the energy-rich Middle East as the US has tried to step back.

Specifically, if China and Iran develop their deal on the ground and China expands the power of its Djibouti naval base with further ship-building, one could potentially see a not-too-distant future where oil flows to China via the Belt and Road and, at the same time, China could be able to close off the Straits of Hormuz and the Red Sea if it wanted, making it primus inter pares. That’s the stick that it would not want to use; the carrot would be helping all sides on trade, infrastructure, weapons, and nuclear energy (For a more detailed run-down, see here.) Even the carrot is a highly explosive prospect given what it implies for energy pricing and so the future of the US dollar. Indeed, it is something the US won’t just sit back and let happen under President Trump or any other president.

Meanwhile, Turkey has its own controversial Mediterranean energy claims it is pressing ahead with, to which France has reacted with talk of sending naval vessels to Cyprus. Markets are already on edge here, with USD/TRY testing towards the psychological 7 level and overnight interest rates hitting as high as 1,024%(!) yesterday: a volatile fusion of markets and geopolitics is at play again, it seems, which does not likely to get better anytime soon.

Likewise as talks to see Indian and Chinese forces --now including tens of thousands of men, heavy tanks, and planes-- pull back from their disputed border have stalled. India is insisting China retreats from all the territory it has taken; China is literally digging in and insisting India drops its economic boycott of Chinese goods and services. Indian analysis underlines New Delhi faces a stark choice between accepting the loss of territory so far (and China the loss of influence and Indian market share) or pushing ahead militarily to reclaim the land – which would obviously be explosive. Markets are assuming it must be the former, “obviously”. Then again, markets didn’t see the border clash coming. They so often miss the obvious.

Like Bloomberg reporting “Highest-Level US Trip to Taiwan in Decades to Challenge China”, as the US Secretary for Health and Human Services) takes the largest and most senior delegation to Taipei for 40 years with an itinerary including meeting President Tsai Ing-wen. The Indian press has also been pushing for New Delhi to swing behind Taiwan to show China that it can take the diplomatic offensive, and not just always play catch-up defence. This is again all highly explosive.  

Sticking with things that are easier for markets to get their heads round, but also dangerous, the US and China will review progress of their phase one trade deal on 15 August and, as Reuters puts it, “air other grievances”. Which I presume will include TikTok. It does not take much analysis to see that China is far behind on its pledged purchase commitments from the US. That could be put down to Covid-19, of course. What cannot, however, is Beijing pushing ahead with a focus on the domestic market at the expense of imports wherever possible; and in particular in the policy unveiled yesterday to support the development of integrated chip manufacturing by offering ten years of no corporate taxes. Recall the US still holds the leading edge (with Taiwan) in this field, and China is still a large net importer of them: this looks like import substitution, which USTR Lighthizer will be able to see all the way from DC. Imagine if the trade deal were to *officially* collapse – which is something we see happening eventually. Imagine how markets will react then.

Especially in the case if there is still no big bang up in Washington DC on stimulus by then. The latest is talk of both sides digging in, and of possible executive orders of questionable constitutionality, and all the while as nearly USD2 trillion provided by the Fed sits there in the Treasury accounts and not in household pockets.

Markets at least get an inkling of how explosive that combination is when we see bond yields moving towards new lows. 10-year Treasuries are now at 0.51% and look to be heading for a sub-0.50% close ahead. 2-years are at just 0.11% and heading for single digits. 5-years are already just below 0.20%. Even 30-years are at 1.20%, roughly pricing in four Fed hikes over the course of the next generation. And that’s with most people in the market blissfully unaware of the prevailing geopolitical backdrop.