China stimulus may knock U.S. Treasuries near term

By John Parry

NEW YORK (Reuters) - China's mammoth economic stimulus package announced this week is the latest piece of bad news for U.S. Treasury bonds as the market prepares for a borrowing requirement to fund the U.S. government's bailout of the banking system.

Bond investors are concerned China may either trim its huge U.S. Treasuries holdings to pay for the country's $586 billion stimulus package, or slow its purchases of U.S. government debt.

To make matters worse, analysts expect a huge acceleration in U.S. government debt issuance running to some $2 trillion over the next year, swelling the size of the $4.9 trillion Treasury market and weighing on the prices of these securities.

Add it up and prices should fall and yields surge, analysts worry.

"The immediate kneejerk reaction in Treasuries appeared to be a supply-related shock on the possibility that China would have to sell Treasuries to raise cash for the infrastructure spending," said Bill Kohli, managing director, global specialist core fixed income with Putnam Investments in Boston.

But for now, a sharp deterioration in the U.S. economy, together with rapidly vanishing inflation as global commodity prices fall, is supporting U.S. government bond prices and keeping down yields.

After news of China's stimulus plan hit the U.S. Treasury market on Monday, the initial market reaction was quickly absorbed by "the overwhelming tide, toward risk aversion and slowdown fears" for the global economy, Kohli said. Flows out of riskier assets and fears about the economic downturn drive safe-haven capital flows into Treasuries.

Yet that market move may mask the longer term danger of the surge in supply of longer dated sovereign debt globally as governments ramp up debt issuance to pay for their attempts to shore up growth.