Are foreign investors losing interest in US Treasury bonds?

China and Japan were among the nations that reduced US debt holdings in April.

The US Treasury Department building.

Just as the US government has decided it wants to borrow more than ever, foreign investors have decided they’re not so eager to lend.

In April, foreign investors pumped only $41.9 billion into US Treasury bonds, down from about $55 billion in March.

This doesn't necessarily portend a run on the dollar or a new crisis for the US economy. But it may help explain why the cost of borrowing money has been going up for the US Treasury – costs that will be shouldered by taxpayers for years to come.

Some of the most prominent nations reduced their Treasury holdings in April, although the total of all foreign holdings of US debt dipped only slightly. China pared its stake by $4.4 billion, to $763.5 billion total. Japan, which ranks second to China in Treasury holdings, also posted a small decrease. So did Russia, Brazil, and oil exporting nations.

Weak foreign demand comes as the Treasury would like foreign investors to buy more of its bonds, not less. The government is issuing debt at a prodigious pace, and counting on foreign investors to buy much of it. Economists at Goldman Sachs project that new borrowing by the government will total $1.7 trillion in the final half of the 2009 fiscal year, followed by $1.4 trillion in 2010 and $1 trillion in 2011.

Is this the beginning of fiscal Armageddon for the world’s largest debtor nation? Most investment analysts say no. Foreign central banks, for instance, aren’t trying to unload their US debt holdings. The shift away from Treasury bonds by investors is driven partly by growing confidence in an economic recovery, which has prompted more money to flow into stock markets worldwide. But the US still faces a fiscal challenge.

“The shift in global preferences back to equities, which seems rational, comes at an inconvenient time when there are heavy auctions of US Treasury securities,” Brian Bethune, an economist at IHS Global Insight, writes. This partly explains “the sharp decline in US bond prices that we have seen in the past couple of months.”

He says the Federal Reserve now has difficult choices to make. The Fed has pledged to be a buyer of both US Treasury bonds and government-backed mortgage agency bonds, in an effort to keep interest rates low and boost the economy. Weakening demand for Treasuries could test just how far the Fed is willing and able to go by intervening in bond markets. So far, the Fed has said it may buy about $300 billion in Treasury bonds this year.

If investors at home and abroad continue to shift money gradually away toward stocks, and away from government bonds, the effect will be to put upward pressure on interest rates. Already, that trend has been evident in recent weeks, with US mortgage rates jumping and the 10-year Treasury bond yielding as high as 4 percent last week.

The challenge goes beyond the US. Governments around the world have been spending extra to stimulate recession-bound economies. The result is that the supply of government bonds may be growing much faster than demand.

So far, what’s happened in recent weeks looks more like a stabilization of the bond market – after a period of crisis when market panic pushed Treasury interest rates to unusual lows – than a spread of worries about whether America can pay its debts. In Treasury debt auctions last week, 10-year bond yields reached 4 percent, a big jump upward but still historically low. And in trading Monday, the pressure on Treasury yields eased a bit, with rates falling back below 3.8 percent.

The question is what comes next. Many nations, including Russia and China, are saying they want to diversify their investments to be less tethered to the dollar. But holders of dollar assets would only hurt themselves by rushing to sell them (since the selling would push down the prices of their investments). And China, for one, still has an export-oriented economy with interests in helping America finance its purchases of imported goods.

The result of these forces, tugging in various directions, could be a gradual rise in Treasury interest rates. Even if it’s not a crisis for the dollar, it could be enough to put pressure on Washington policymakers to rein in high federal budget deficits.

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