NEW YORK (Reuters) - China’s mammoth economic stimulus package announced this week is the latest piece of bad news for U.S. Treasury bonds as the market prepares for a borrowing requirement to fund the U.S. government’s bailout of the banking system.

Bond investors are concerned China may either trim its huge U.S. Treasuries holdings to pay for the country’s $586 billion stimulus package, or slow its purchases of U.S. government debt.

To make matters worse, analysts expect a huge acceleration in U.S. government debt issuance running to some $2 trillion over the next year, swelling the size of the $4.9 trillion Treasury market and weighing on the prices of these securities.

Add it up and prices should fall and yields surge, analysts worry.

“The immediate knee-jerk reaction in Treasuries appeared to be a supply-related shock on the possibility that China would have to sell Treasuries to raise cash for the infrastructure spending,” said Bill Kohli, managing director, global specialist core fixed income with Putnam Investments in Boston.

But for now, a sharp deterioration in the U.S. economy, together with rapidly vanishing inflation as global commodity prices fall, is supporting U.S. government bond prices and keeping down yields.

After news of China’s stimulus plan hit the U.S. Treasury market on Monday, the initial market reaction was quickly absorbed by “the overwhelming tide, toward risk aversion and slowdown fears” for the global economy, Kohli said. Flows out of riskier assets and fears about the economic downturn drive safe-haven capital flows into Treasuries.

Yet that market move may mask the longer term danger of the surge in supply of longer dated sovereign debt globally as governments ramp up debt issuance to pay for their attempts to shore up growth.

“Longer term, budget issues and government debt levels are all going to be putting pressure on the longer end of government debt curves,” as governments bail out private institutions and take on their liabilities, said Kohli.

To finance its huge $586 billion economic stimulus plan, China “will have to either sell its holdings of U.S. Treasury and agency securities, or slow its rate of accumulation in these securities,” wrote Tony Crescenzi, chief bond market strategist with Miller, Tabak & Co. in a research note.

Beyond the Treasury market, the plunging U.S. housing market needs lower mortgage rates before it can stabilize. But if the 10-year Treasury note’s yield spiked higher, U.S. house prices have little chance of stabilizing as mortgage rates are priced off the U.S. Treasury yield curve.

When debt issued by the now government-controlled mortgage finance giants Fannie Mae and Freddie Mac is added, China holds between $1 trillion and $1.5 trillion of U.S. debt securities, analysts estimate.

“I don’t think they will need to sell Treasury assets. There are other assets they can sell,” said Robert Kapito, president of asset management firm Blackrock, speaking at a Reuters Summit on Tuesday.

China could sell U.S. mortgage-backed securities or the debt of agencies, such as Fannie Mae or Freddie Mac, which would have an impact on these U.S. fixed income markets, Kapito said.

Money to fund China’s stimulus package, much of it for infrastructure projects, will most likely come from the nearly $2 trillion of foreign reserves held by the Chinese government, the lion’s share of which is in U.S. Treasury and agency debt, which “in reality amounts to a subsidy of the U.S. economy,” wrote Peter Schiff, president and chief global strategist with Euro Pacific Capital in a research note on Monday.

“If it does tap into this ocean of cash, China will become a net seller of U.S. Treasuries just as the U.S. will be issuing a record supply,” Schiff wrote. “With two huge sellers and just about every major creditor nation having problems of their own, the Federal Reserve will be the only buyer,” he added.

LONG TERM OUTLOOK:

However, over the long term the impact of China needing $600 billion to spend over a two-year period may not drive up U.S. Treasury yields much. China currently runs up a trade surplus of about $250 billion a year, and even as world economic growth brakes sharply, will still generate some $150 billion annually, enough to pay for most of the plan, expects Sung Won Sohn, professor of economics at California State University in Camarillo, California.

With these surpluses, “they will have plenty of money to finance the project,” Sohn said.

Another worry for global bond markets is that should China’s economic stimulus plan help the world economy rebound, that will lessen the appeal of government bonds, which rally in hard economic times. Yet Sohn does not expect a major global impact from China’s initiative.

“In the past we have heard similar stories of the Chinese trying to shuffle their reserves and it only had a temporary effect,” Sohn said.

Even so, near term, sales of a comparatively small amount of, say $20 billion of Treasuries “could have a meaningful impact on yields in the short run,” Sohn said.