Traders are bracing for U.S. House Speaker Nancy Pelosi's expected arrival in Taipei to raise tensions with China, with stocks sliding and haven assets such as the yen and Treasuries climbing.

U.S. 10-year yields dropped for a fifth day and approached 2.5%, a level last seen in April, before paring the drop. The Japanese currency advanced to the strongest level in nearly two months. Equity markets in China and Hong Kong were the worst performers in Asia as security analysts outlined potential military responses from Beijing. U.S. index futures dipped along with stocks in Europe.

Pelosi's trip is creating a fresh pressure point for investors already dealing with the prospects of a U.S. recession, worldwide rate hikes and surging inflation. The moves so far suggest traders are hedging against tension escalating, with analysts warning of the tailrisk of a conflict between the world's two largest economies that wreaks havoc on global markets.

"China will show her displeasure by ratcheting up retaliatory actions, but it won't get out of hand given its economy is weak," said Rajeev De Mello, a global macro portfolio manager at GAMA Asset Management in Geneva. "However, the risk is if there is any military 'incident,' which could lead to an accidental military escalation, which would stress global financial markets."

While the White House has sought to dial back rising tensions by insisting there is no change in its position toward Taiwan, which China considers as part of its territory, Beijing has called Pelosi's visit a "dangerous gamble" with grave consequences. It has responded to past visits by foreign officials with large sorties into Taiwan's air defense identification zone or across the median line that divides the strait.

China's benchmark stock gauge closed down almost 2%, while Hong Kong's Hang Seng Index dropped 2.4%, with a smaller decline seen in Taiwan. The Taiwan dollar hit its lowest since May 2020, before paring the drop on signs that local banks were selling the greenback to meet the needs of foreign funds.

One-month risk-reversals on the U.S. dollar-Taiwan dollar currency pair jumped to the highest since May, signaling traders are betting the island's currency will weaken.

U.S.-listed Chinese stocks are on track to fall for a fourth day, which would mark the group's longest streak of losses since June. American depositary receipts of Alibaba Group Holding Ltd. and Baidu Inc. were among the biggest decliners in premarket trading Tuesday.

Some analysts warn the impact of Pelosi's visit will hasten the deterioration in U.S.-China ties. The concern is that the trip and China's reaction to it worsens the longer-term relationship on trade, and plays out in markets over weeks or more, with implications for Treasuries, according to BMO Capital Markets strategists Ian Lyngen and Benjamin Jeffery. Yields on the 10-year benchmark may well drop below 2.5% this week, they wrote in a report.

Pelosi is expected to arrive at 10:20 p.m. local time via private plane at Songshan Airport, according to the Liberty Times, one of several media outlets linked to Taiwan President Tsai Ing-wen's ruling party. As House Speaker she's second in line of succession to the U.S. presidency, making her visit to the democratically ruled island an affront to Beijing.

Despite the tensions, global risk assets have been relatively resilient. S&P 500 futures slipped about 0.7% and Europe's benchmark stock index retreated 0.8%, with mixed earnings also weighing on sentiment. Most emerging-market currencies weakened, while copper extended a decline along with other industrial metals. Gold edged higher.

"The expectation is that China's reaction will mostly be confined to some signaling actions, instead of something really hurting their economy, and therefore at this stage, we view the market's reaction has so far been relatively mild," Becky Liu, head of China macro strategy at Standard Chartered Bank Plc, told Bloomberg Radio. "We just need to be concerned about the medium-to long-term implications."

Taiwan Semiconductor Manufacturing Co., the world's largest chipmaker, fell 2.4%. The stock has declined about 20% this year with Taiwan's stock benchmark down 19%, slightly worse than the 17% decline in the MSCI AC Asia Pacific index.

Still, investors may need to prepare for a drawn-out reaction in financial markets, something which could underpin haven assets like Treasuries.

"Pelosi's visit carries with it the presumption of a limited time frame for a tradable response; an assumption that we'll characterize as misplaced," BMO's Lyngen and Jeffery wrote in their note. "Any response could be weeks away or further and for this reason we anticipate that the geopolitical backdrop will once again contribute to the bullish underpinnings for the U.S. rates market."

Cormac Mullen and Karl Lester M. Yap report for Bloomberg News.

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