Investors are failing to factor in the very real risk of China scaling back on its U.S. government debt holdings, economist Stephen Roach told CNBC.
"Everyone thinks interest rates are going to stay low in the U.S. because the Fed is in the control room... but the Chinese own about 11 percent of the Treasury market right now, and as they start to reduce their purchases of dollar-based assets... [this] will mean higher interest rates," he told CNBC Asia's Squawk Box.
related investing news
The political crisis in Washington that saw a 16-day partial U.S. government shutdown damaged the perception of the U.S. government's credibility abroad, analysts say, prompting fears that China may reassess its investment in U.S. Treasurys.
China is the world's largest overseas holder of U.S. government debt; any move to sell out of the asset class could prompt a spike in Treasury yields, and therefore benchmark interest rates. Data from the U.S. Treasury department this week showed that China reduced its holdings in U.S. Treasurys to $1.268 trillion in August, down by $11.2 billion from July.
According to Roach, as China starts to reduce its savings surplus and accumulate foreign reserves at a slower pace, its demand for dollar-based assets, like Treasurys, will decline.
"China is on the move with a different [economic] model and there are enormous consequences for its purchases of Treasurys and other dollar-based assets as a result. America has got to face up to that," he said.
China buys U.S. Treasurys as part of its currency management strategy. By recycling its foreign exchange reserves into T-bills, it prevents its domestic currency from rising, which would threaten the competitiveness of its exports.
(Read More: China wonders:Why do we own so much U.S. debt?)
Most analysts have dismissed fears of China cutting its Treasury holdings, arguing that there is not a large or liquid enough viable alternative. But Roach questioned this argument, noting U.S. investors have become too smug in thinking that China would stick to its holdings for this reason.
"The U.S. is really not focused on the possibility of [China scaling back on Treasurys] because they think very smugly 'where else are they going to go?' And where else are the Chinese is going to go... [they will start] directing their savings at supporting their economy not just America's economy," he said.
Roach added that the recent political crisis in Washington has meant Chinese investors will be even less inclined to maintain their exposure to U.S. government debt.
(Read More: US credibility continues to erode: Gundlach)
"[Chinese currency managers] manage their portfolios on a risk adjusted basis and given the fiasco that Washington just went through, the risk to the ability of Treasurys to hold their value seems to have gone up and they need to make some adjustments accordingly," said Roach.
"I think this is a prudent decision from the standpoint of many Chinese currency managers," he added.
Yields on the 10-year Treasurys have spiked over 100 basis points this year after the Federal Reserve first started talking about tapering its $85-billion-per-month bond-buying program in late May. Yields on 10-year T-bills were trading at around 2.51 percent in early Asian trading on Friday.
(Read More: China's yuan flexes muscle as US crisis rattles on)
—By CNBC's Katie Holliday: Follow her on Twitter @hollidaykatie