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A big risk that may catch the Fed off guard

Genyuan Huang | E+ | Getty Images

As central banks in emerging markets struggle to arrest the rapid decline in their currencies, they may be forced to liquidate holdings of U.S. Treasurys - a risk, analysts say, that could catch the Federal Reserve off guard.

"I haven't seen evidence of it yet but selling U.S. Treasuries would be a very logical way for emerging market nations to shore up their currencies. They are fighting an uphill battle here and any step could help," Kathy Lien, managing director of currency strategy at BK Asset Management told CNBC on Friday.

(Read more: Emerging markets: dissecting the good from bad)

"I don't think the Fed [Federal Reserve] is overly concerned about it, but they should be," she said.

Rapid selling of U.S. government bonds by foreigners would put upward pressure on yields, sending borrowing costs higher. The yield on benchmark 10-year bonds this week rose to 2.93 percent, their highest in two years.

Emerging market central banks are major foreign holders of U.S. government securities, with China, Brazil and Taiwan and Russia among the largest, according to data from the U.S. Treasury.

China, the largest foreign creditor to the U.S., holds the highest amount at $1.27 trillion, while Brazil, Taiwan and Russia hold $254 billion, $186 billion and $138 billion, respectively.

"The latest TIC [Treasury International Capital] data did show significant foreign selling of U.S. Treasurys - there may be a pattern developing here," said Mitul Kotecha, global head of currency strategy at Credit Agricole.

Foreigners sold $66.9 billion of long-term U.S. securities in June, a fifth straight month of outflows and the largest since August 2007, led by China and Japan, which is the second biggest foreign holder of U.S. bonds.

(Read more: The biggest holders of US government debt)

While China may not need to sell U.S. government bonds to support its currency, given that it is holding up well, Kotecha noted that a desire to diversify its assets or the underperformance of Treasurys could prompt the country's central bank to further liquidate some of its holdings.

Marcus Huie, rates strategist at Bank of America Merill Lynch, also acknowledged the risk central banks in beaten-down emerging markets offloading their Treasury holdings.

"Initially, growing expectation of the initiation of Fed tapering in September drove yields higher, which in turn led to selling of emerging market currencies. However, recent emerging market currency declines has fed fears of central bank reserve selling and led to rising Treasury yields," Huie said in a report this week.

(Read more: Emerging market taper terror 'quite overdone': Mobius)

"This two-way causation raises the risk of a self-reinforcing cycle between the bond and currency markets, where the Treasury reserve assets are themselves vulnerable to losing value," he said.

—By CNBC's Ansuya Harjani; Follow her on Twitter @Ansuya_H

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