Consider it China's nuclear option in the trade war with the U.S. — the ability to start dumping its massive pile of Treasury bonds that could trigger a surge in interest rates and substantially damage the American economy. As the two sides engage in a tit-for-tat tariff exchange, the possibility that China might raise the stakes and stop being the world's biggest consumer of U.S. debt again reared its imposing head Monday. China currently owns $1.13 trillion in Treasurys, a fraction of the total $22 trillion in U.S. debt outstanding but 17.7% of the various securities held by foreign governments, according to data from the Treasury and the Securities Industry and Financial Markets Association. Should the Chinese decide to walk away or reduce their role in the market, that, at least in theory, could create a substantial dislocation for a country such as the U.S. that relies so much on sovereign entities to buy its paper.

At least for the moment, markets aren't that worried that China could take such a seemingly drastic step, in large part because the move might not have much upside except to create headlines. "It's a self-destructive nuclear option," said Robert Tipp, chief investment strategist and head of global bonds for PGIM Fixed Income. "Maybe it helps them as a bargaining chip, but it's endangering the value of something they're deeply involved in." In fact, the move actually could help the U.S. For one, a Chinese reduction of Treasurys could weaken the dollar and make U.S. multinationals more competitive. For another, Treasury yields would rise and thus cause prices to fall, lowering the value of China's portfolio. And there's the question of where China would put its money — all that cash would have to go somewhere, and U.S. bonds are among the highest-yielding in the world when weighed against their relatively low risk. "It still seems like Treasurys are the optimal place for security, flight to quality, capital appreciation etc. Moving around that sum of money seems very challenging now," said Nick Maroutsos, co-head of global bonds for Janus Henderson. "It's possible and could happen very gradually over a six- to 12-month period. But calling it and having it happen so quickly is very unlikely."

'The biggest weapon they have'

In fact, China already has been pulling back its role in the U.S. bond market. Its holdings have fallen nearly 4% over the past 12 months even as total foreign government ownership of Treasurys has increased by 2.6%. Following its myriad disputes with the Trump administration, Russia has largely exited the Treasury market. Japan, the No. 2 holder of U.S. debt, has increased its holdings slightly over the past 12 months to $1.07 trillion, while Brazil has stepped into the No. 3 position with about $308 billion, thanks to a 12.9% boost during the period. With the U.S. expected to be staring down $1 trillion annual budget deficits in the years to come, a less active Chinese government does generate some fears. "To me, that is the biggest worry. This is really the biggest weapon they have," said Sung Won Sohn, professor of economics at Loyola Marymount University and president of SS Economics. "They need to do more to counter the United States. So if push comes to shove, that's what they are going to resort to."

Because the U.S. imports far more from China than the other way around, China needs additional leverage to fight the tariff battle. While Sohn said shrinking its bond holdings would be a last resort, he sees it as possible if the U.S. decides to enact tariffs on all Chinese imports, which totaled $539.5 billion in 2018. "I have become less and less optimistic and more pessimistic, because this is a trade war but it's not as much about economics as it is other things," he said. "In the United States, we view China as an economic predator. China views the United States as a model of Western power trying to humiliate China as in the 18th century. There's a long, kind of simmering underneath of nationalistic feelings."

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