Want to stop China from manipulating the yuan and the dollar? Bar it from buying treasuries, Mr. President.

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By Robert Romano

Don’t look now, but with China’s sharp devaluation of the yuan vis a vis the U.S. dollar, the Federal Reserve slashing its interest rate and and the Treasury designating Beijing as a currency manipulator, the 10-year-2-year treasuries spread may be about to invert.

Meaning, one of the key recession signals may be about to go off.

Since the beginning of July, the spread between the 10-year Treasury and 2-year Treasury has dropped from about 0.25 to 0.09 as of this writing. When it goes below zero, this has traditionally signaled a recession is on the horizon.

Recessions tend to occur on average about 16 months after the 10-year, 2-year inverts, and so even if it were to invert right now, that might not forecast a recession until Dec. 2020, after the next election.

And even then, you won’t know it until it’s reported by the Bureau of Economic Analysis a few months later and when unemployment begins significantly rising.

But it could be cutting it close, if one is keeping their eye on the political calendar, with the 2020 presidential election cycle upon us.

Trump is not guaranteed reelection even if the odds tend to favor the incumbent. Therefore, whatever he intends to achieve with China, trade and reversing globalization, this is his moment to succeed or fail. He might get another four years to see it through, but then again he might not.

One thing is certain, it has been a decade since the last recession, and the U.S. economy is long overdue for another one. Since World War II, the U.S. has averaged a recession once every 5.3 years, according to data compiled by the National Bureau of Economic Research.

One key indicator is the federal funds rate set by the Federal Reserve. The central bank kept the interest rate at near-zero percent for almost the entirety of the Obama administration, only significantly beginning the hiking cycle after the 2016 election. Arguably that was too long. It probably could have safely begun hiking back in 2014 or 2015. If so, the recession might have already happened.

We tend to judge these things in hindsight. Many argued that the Fed made the same mistake in the 2000s, leaving interest rates too low for too long, and that the devastation of the financial crisis and the Great Recession could in part be attributed to that.

If the next recession is steep, undoubtedly fingers will be pointed at the Fed for waiting too long. And even if it is not so steep, a certain amount of blame will be leveled. As it is, you would have to ask former Federal Reserve Chairwoman Janet Yellen her rationale for keeping the rates low for as long as she did.

For now, other indicators for the U.S. economy seem good. Unemployment remains near 50-year lows at 3.7 percent. Almost 5.2 million jobs have been created since Jan. 2017 in the household survey. The economy is still growing.

Can anything be done to keep it going? Probably not, if you believe in that the economy operates in cycles. But there are still factors that policymakers and the President ought to consider over the longer term, circling back to the trade and currency dispute with China.

Now that the U.S. Treasury has labeled China a currency manipulator, it should consider barring it from purchasing any more treasuries as a penalty. After all, China needs to keep buying treasuries to exert its trade advantage. Currently it holds $1.1. trillion and is the world’s largest holder. Exporters tend to stockpile dollar-denominated assets to weaken the local currency. Without treasuries to fall back on, the yuan could appreciate vis a vis the dollar, even with the fixed exchange rate.

That would give the tariffs, now 25 percent on $250 billion of Chinese goods, and 10 percent on the rest of the $300 billion of them, some real teeth. It would also create a very real penalty for currency manipulation, and serve as a deterrent to other countries that want to play games with the dollar.

Such a move might also ease demand for treasuries, placing pressure on interest rates to rise, perhaps easing the imminent inversion temporarily. China might respond and consider dumping its treasuries in response, but that too would hasten the yuan’s appreciation .

While these developments would create pressure for treasuries interest rates to rise, this would be offset by a market panic into treasuries out of equities, as markets and central banks buy up the excess bonds. In fact, fearful of the breakdown of trade talks with the U.S. by China, investors are already doing that. The 10-year treasury is down to 1.6 percent as of this writing amid the trade tensions.

Barring China from treasuries markets might not be able to forestall another recession, and so the rationale has to be long-term. Kicking the currency manipulator China out of treasuries markets as a penalty could help the U.S. achieve an implied aim of the Trump administration to decouple from the Chinese economy, or finally force China to the table to craft a long-desired trade deal, make its foreign exchange operations transparent and let the yuan float once and for all. Would that be such a bad thing?

Robert Romano is the Vice President of Public Policy at Americans for Limited Government. Reproduced with permission. Original can be viewed here.