Are Treasurys Falling Out of Favor With China?

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Reports that China may step up the diversification of its huge foreign exchange reserves is not great news for U.S. Treasurys, already under pressure from talk about an easing in the Federal Reserve's bond-buying program. But, the fall-out from such a move is likely to be limited, analysts say.

The body that manages China's currency reserves has set up an operation in New York to invest in private equity, real estate and other assets as it steps up its diversification away from U.S. government bonds, the Wall Street Journal reported late Monday, citing sources familiar with the move.

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China has the biggest currency reserves in the world, worth more than $3 trillion. It's also the biggest foreign holder of U.S. government debt – no surprise then that in recent years any talk that it might unwind some of those bond holdings has led to some nervousness in markets.

"This story has been knocking around for a long time. I suppose if they [Chinese officials] are internationalizing their forex reserves it could be truer now than in the past," said Bank of Singapore's chief economist Richard Jerram.

"At the margin it would be bad news, but then what else is going on? The Japanese QE [quantitative easing] is going to leak into bond markets globally and some of that money is going to support Treasurys," he added, referring to the Bank of Japan's aggressive asset-buying program.

Renewed talk that the Fed is starting to mull an unwinding of its bond-buying program has pushed U.S. Treasury yields higher. The yield on benchmark 10-year bonds is around 1.97 percent, close to two-month highs hit last week at 1.985 percent.

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"It may be that they [the Chinese] are anticipating yields to rise over the next one or two years and may want to pull back a little," Jerram said.

Less Appealing?

In a sign that Chinese appetite for U.S. government bonds may be waning, latest data on foreign holdings of Treasurys show that China held about $1.250 trillion worth of U.S. debt in March compared with about $1.251 trillion in February.

"You see the Chinese are concerned about holding Treasurys," Axel Merk, chief investment officer at Merk Investments told CNBC Asia's "Squawk Box," referring to the reports on the diversification of China's reserves.

However, looking at the big picture, the prospect of the Fed unwinding its ultra-lose monetary policy is likely to be a greater headwind for Treasurys than any diversification of China's currency reserves, analysts said.

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"We don't need the Chinese to dump bonds for there to be trouble in the bond market. What we need is to have a return to historic levels of volatility," Merk said.

"The bond market has been an eerily quiet place. Economic growth can bring that volatility into the market and that will unleash a momentum [that could push] players out of the market and who knows where that will end. [Fed chief Ben] Bernanke's efforts have been aimed at keeping the long–end of the yield curve safe," he added.

The Fed is currently buying $85 billion worth of U.S. Treasury and mortgage-backed bonds every month and its asset-buying has helped keep interest rates low, helping the economy recover.

"Realistically, the timing and nature of the Fed tapering QE is the dominant factor for Treasurys and I wouldn't have thought that this kind of thing [China's forex diversification] could be a big deal," said Bank of Singapore's Jerram.

By CNBC.Com's Dhara Ranasinghe; follow her on Twitter @DharaCNBC