Bloomberg on Wednesday reported that senior officials reviewing China's foreign currency holdings had recommended slowing or halting purchases of U.S. Treasurys because the debt is less attractive than other assets and, possibly, because of U.S. trade tensions.

A threat by unnamed Chinese officials to stop or slow U.S. Treasury buying is being taken somewhat seriously by the bond market and is seen as a potential political message to Washington.

The report comes as rates were already rising on concerns that the Fed and other central banks were tightening policy and governments, including the U.S., were issuing a pile of new debt.

Strategists say, however, that they do not expect China to sell Treasurys or do much to damage the market where it is the biggest holder. If China does abstain from purchasing Treasurys this year, U.S. interest rates on the margin could rise more than expected. Currently, strategists mostly see the key yield on the benchmark 10-year Treasury topping out at about 3 percent.

The Trump administration is expected to issue two key trade decisions on steel and aluminum later this month, both of which could affect China. Worries about protectionist trade practices around NAFTA and China have been a major risk factor for financial markets.

"It's hard to know how much credibility to assign to [the report,] but it probably originates from somewhere and as a result I think the market is interpreting this as a potential shift in strategy," said Mark Cabana, head of U.S. short rate strategy at Bank of America Merrill Lynch. "It's hard to know how much of this is politics, which certainly seems to be some piece of this given the report cited political developments, such as trade disputes. It does seem politically motivated."

Cabana has expected Treasurys to be under pressure this quarter due in part to increased supply, and less demand from overseas would fit that scenario.

"We're of the view if you're a reserve manager, Treasurys aren't terribly attractive. If you're China, you don't have too many options, but this could certainly mean they could diversify into euros more or in U.S. dollar terms, hold more in cash," he said.

China has foreign reserves of about $3.1 trillion, and the U.S. government reported it held $1.189 trillion in Treasurys as of October. Those holdings are below the five-year average of $1.226 trillion, according to Cabana.

"No one has come out and denied it as far as I can tell," said George Goncalves, head of fixed income strategy at Nomura. "It does seem it was some sort of messaging."

When the report hit, Treasury yields, already in an upswing, moved higher with the 10-year yield reaching 2.597 percent, its highest since March 15. The U.S. dollar weakened, losing 1 percent against the yen and 0.3 percent against the euro.

"This is not the death knell for the dollar. It is not even the fatal blow for the Treasury market. It's just a reminder that we are dependent on overseas investors," Goncavles said.

Strategists said the market is taking the comment seriously despite the fact that there is no named source in the story. But the story did gain some credibility because it followed a report Tuesday that China was dropping a currency adjustment mechanism, which could make it less reliant on intervention to support the yuan and therefore require less dollar investment.

Even without the political element, China may see U.S. Treasurys as simply less attractive. "Is there value buying the bond market when there's potential for inflation moving higher, and we're doing a lot of fiscal spending, at a time when the economy is near full employment? We're going to issue new debt. Like any debtholder around the world, you look up and say: 'Are you being fiscally responsible?'" said Goncalves.

Cabana said U.S. debt issuance is expected to rise by $550 billion in 2018, or 1.7 times as much as last year. That is to help pay for the U.S. tax cuts that went into law Jan. 1 and the increase in entitlement costs.

Alan Ruskin, head of G10 foreign exchange strategy at Deutsche Bank, said he sees limited impact from the China comments. "There are some good arguments why China's bark will prove a lot worse than its bite," he said, noting in the five-year sector, U.S. yields are better than alternatives.

That is a sector central banks favor, and the U.S. yield is superior to the negative 20 basis points on German debt, or the negative 8 on Japanese debt.

"Most [of] these alternative markets are also far behind the US in finding a soft-landing exit from extreme monetary accommodation, making future potential capital losses a worrying factor," Ruskin wrote. "The only G10 countries that can compete are Canada, Australia and NZ, but it's hard to see how China can start shifting much of its $1.2 trillion Treasuries, without being hugely disruptive to much less liquid markets over the short and medium term."

He noted that China holds so much U.S. debt that any small action would damage its existing stock of assets and its portfolio.

"During the 2008 crisis, China appeared to fully understand the ramifications of its potential selling of Treasuries and did not become a disruptive force for USD fixed income, even as [Treasury capital flow] data showed a shift from agencies into very short-term T-Bills," Ruskin added.

At Jefferies, Ward McCarthy, chief financial economist, noted that if China stops buying Treasurys, the market could suffer.

"Treasury financing needs are going to rise significantly in 2018 and beyond relative to recent history, so Treasury is going to be looking for as many sources of demand as they can find," he wrote. "China turning away from the market potentially makes Treasury's job harder. However, this prospect might already be old news since there is evidence that China has not been a big buyer of Treasuries for several years now."

He noted that from January 2007 through July 2011, Chinese holdings of Treasury notes and bonds rose from $401 billion to $1.315 trillion. But since that time, Chinese holdings have fallen to $1.189 trillion and touched as low as $1.049 trillion in January 2017.

Source: Courtesy of Jefferies