Will China keep buying U.S. bonds?

By Liz Rappaport and James T. Areddy
The Wall Street Journal
Friday, July 31, 2009

http://online.wsj.com/article/SB124896282178793797.html?

Shaky auctions of Treasury notes this week reignited concerns about whether the government can attract buyers from China and elsewhere to soak up trillions in new debt.

A fuse was lit this week when traders noted China's apparent absence from direct participation in two Treasury bond auctions. While China may have bought Treasurys just before the auctions, market participants read the country's actions as a worrying sign that China and other foreign investors may be ratcheting back purchases at a time when the U.S. is seeking to fund a $1.8 trillion budget deficit.

This week alone, the U.S. deluged the bond market with more than $200 billion in record-size sales. The U.S. has had little trouble finding buyers in recent months. But that demand is fading, and the Treasury market has become volatile. Many are selling in favor of riskier assets such as corporate bonds, stocks or even higher-yielding debt of other countries. This portends higher interest rates for the Treasury, and it may need to find alternative sources of cash like issuing more inflation protected Treasury bonds.

Tension on Wall Street trading desks began building late last week when the Treasury surprised the market with plans for a record week of sales. A Monday sale of $90 billion in Treasury bills with maturities of as much as a year went well. But China appeared absent from the following two sales, which totaled $81 billion of debt, traders say.

By Thursday morning, trading-desk heads were frantically working with clients to ensure a better fate for the $28 billion seven-year note auction. It did fare far better, allaying some concerns.

"We believe by maintaining the deepest, most liquid market in the world, we will continue to attract capital from a broad array of investors," said Andrew Williams, a spokesman for the Treasury Department.

The seven-year Treasury note rose after the auction, gaining 3/32 point Thursday to 99 25/32, which lowered its yield to 3.285%. The 10-year Treasury also gained in price on the day, up 6/32 to yield 3.641%.

Details about the auctions aren't revealed by the government until weeks later. Overseas buyers initially are lumped together into a category known as "indirect bidders," giving little insight into the origins of demand. It may be months until more thorough data on foreign-government buying are released by the U.S. Treasury. Foreign investors had been substantial bidders in recent Treasury auctions, even though their holdings of Treasury debt had started to wane. But this week's auctions renewed worries that central banks and other buyers will start selling more aggressively.

"If this trend continues, it could reflect foreign buyers' increasing concerns about the creditworthiness of the U.S.," said James Bianco, president of Bianco Research.

The worries over China shine a light on the potential vulnerability of the U.S. as it tries to fund is budget hole. Last year, China led foreign investors in selling mortgage securities guaranteed by government entities Fannie Mae and Freddie Mac, according to Treasury Department data. They also sold corporate bonds as the global financial crisis ramped up. They have not dipped back into these asset classes despite a huge rally in corporate bonds and mortgage debt this year.

While no one at State Administration of Foreign Exchange, which manages China's $2 trillion, would comment on the latest Treasury auctions, the government has left little doubt it fears the portfolio is at risk.

Clipped comments from government officials, amplified by state media editorials, point to a worry the U.S. will ultimately address its massive debt obligations by permitting inflation to rise or letting the U.S. dollar sink -- factors that would erode the value of Treasurys owned by foreign investors such as China.

At economic talks in Washington this week, senior Chinese officials gave their Obama administration counterparts an earful about the burgeoning U.S. budget deficit. China made clear it wants the U.S. to "protect its investment assets" for the good of the bilateral relationship, as the state-run Xinhua news agency reported.

The gravity of Beijing's concern was reiterated with blanket coverage of the talks in Chinese newspapers, which generally praised Washington for treating seriously its concerns. Global Times, a nationalistic English-language paper, published a front-page photo showing U.S. Federal Reserve Board Chairman Ben Bernanke appearing anxious, perched on the edge of a chair and listening as Chinese Vice Premier Wang Qishan makes a point.

The Chinese are also in a bind. If they sow doubts about the solvency of the U.S. government, they risk driving down the value of the $800 billion in U.S. Treasurys they already own.

The Chinese government's Treasury strategy is a closely guarded secret, and analysts were hard-pressed to identify any evidence that might suggest an adjustment was suddenly under way. "We worry about the devaluation of the U.S. dollar, but not at this stage," said Yang Hui, a bond salesman at Citic Securities Co. in Beijing.

* * *

To contribute to GATA, please visit:

http://www.gata.org/node/16