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The Biggest Risk for Asian Markets (It's Not China)

Gandee Vasan | Stone | Getty Images

The biggest risk for beaten-down Asian markets is not China's financial instability, say experts, it's a further spike in U.S. Treasury yields.

"If U.S. [10-year] Treasury yields go up from here to 3 percent - that's going to be a disaster for the asset markets in Asia," Kelvin Tay, regional chief investment officer, southern Asia-Pacific, at UBS told CNBC.

"It's going to shift a lot of capital away and it will basically hasten the liquidity movements out of this region," he added.

(Read More: Market Consensus: Get Ready for 3% Treasury Yields)

The U.S. 10-year Treasury yield has risen sharply since the beginning of May, from 1.6 percent to 2.61 percent currently, driven by expectations that the Federal Reserve will begin scaling back its bond buying program as early as September.

The narrowing spread between U.S. and Asian government bond yields, has led investors to sell the latter in favor of safe-haven Treasurys, which in turn has had a negative impact on Asian currencies and equities.

Investors pulled $1.5 billion out from emerging market bond funds in the week ended June 5, according to fund tracker EPFR, while equity funds lost $5 billion - their biggest outflow in almost two years.

(Read More: Why the Rise in Treasury Yields May Be OK)

Meanwhile, Asian currencies have also seen a rout. The Malaysian ringgit, for example, has fallen 4.3 percent against the U.S. dollar since the beginning of May, while the Thai baht has plunged 6.1 percent over the same time period.

The MSCI Asia Pacific ex-Japan stock index has also fallen 11 percent over the past month.

Timing Is Key

Dhiren Sarin, chief technical strategist for Asia-Pacific at Barclays, agrees that a move to 3 percent yield on the U.S. 10-year government bond is a risk for the region's markets, but how much impact it will have will depend on how swiftly this level is reached.

"If we get there in the next week or two, it will cause a lot of stress in emerging markets. The faster it goes the more scare it causes over the cost of funding and there would be a rapid escape from emerging markets," Sarin said, noting that such a scenario would cause emerging market equities to fall to multi-year lows.

If it is a more gradual move higher, then asset managers will have time to reassess and reallocate their portfolio holdings, he added, which would be more "palatable for risk appetite."

At this point, both Sarin and Tay say they don't expect yields to rise at a rapid rate, but it remains a risk.

(Read More: Cramer: Bernanke's Fed Has Lost Control of Bond Market)

"I think the Federal Reserve is probably cognizant of the destabilization effects of that. If yields go up very sharply I'm pretty sure the Fed will come up with some form of rhetoric to talk the markets down," said Tay.

Mark Matthews, head of research, Asia at Bank Julius Baer, agrees the central bank will likely be reactive to a drastic move in yields.

"This central bank is clearly reactive to financial markets If they wanted to they could reverse their policies. That would look pretty sloppy, but in a worst case scenario they could," Matthews added.

—By CNBC's Ansuya Harjani

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