NEW YORK (Reuters) - Foreign investors are showing signs of fatigue in absorbing the supply of Treasuries that is growing due to the U.S. government’s ballooning budget gap, posing a risk that bond yields will eventually spike.

FILE PHOTO: A sign marks the U.S Treasury Department in Washington, U.S., August 6, 2018. REUTERS/Brian Snyder/File Photo

The rising stockpile of federal debt to finance a U.S. deficit that is projected to hit $1 trillion in two years has stoked concerns whether overseas appetite for it is approaching saturation.

Signs of waning enthusiasm from this major group of Treasuries holders have yet to hurt the $15 trillion Treasuries market, analysts said. The yield on benchmark 10-year Treasury notes has struggled to stay above the 3 percent mark since hitting a near-seven-year peak in May.

“That will be a powerful force for U.S. yields to go up,” said Kristina Hooper, chief global strategist at Invesco in New York.

In July, overseas accounts acquired the fewest fixed-rate government debt issues at auctions since at least 2009, according to Reuters’ calculation of Treasury auction data.

Foreigners’ reticence means the government would rely more on domestic banks, fund managers and Wall Street dealers to buy its debt to keep Treasury yields from marching much higher this year.

“Incrementally, foreigners are buying fewer Treasuries, but domestic investors have stepped up and filled in for that group,” said Ed Al-Hussainy, senior interest rate and currency analyst at Columbia Threadneedle Investments in Minneapolis.

Recent safe-haven demand for Treasuries stemming from trade frictions between the United States and China and other nations, and political concerns about Turkey and Italy have kept a lid on bond yields, analysts said.

On Wednesday, the yield on benchmark 10-year Treasury notes was 2.82 percent after peaking near 3.13 percent in

mid-May to its highest in seven years.

(Graphic: Fund managers, foreign buying at U.S. Treasury auctions: reut.rs/2PsyZ7l)

OVERSEAS DEMAND RECEDES

Foreigners’ share of monthly fixed-rate Treasury supply at auction has retreated since the Treasury began ramping up its issuance after the suspension of its statutory debt limit in February. Also, hedging costs for overseas buyers have risen due to an unexpected resurgence in the dollar in the second quarter.

In July, they bought $16.57 billion worth of monthly fixed-rate government bond supply, marking the lowest amount of fixed-rate issuance they purchased going back to at least 2009.

The U.S. Treasury Department sold $170 billion in two-, three-, five-, seven-, 10- and 30-year debt last month.

In June, foreign investors turned net sellers of Treasuries, shedding $48.57 billion, Treasury data released last Thursday showed.

China’s holdings of U.S. government debt slipped to $1.179 trillion in June, the lowest since February, while Japan’s ownership of Treasuries decreased to $1.030 trillion in June, the lowest since October 2011.

China and Japan are the two largest foreign holders of U.S. Treasuries.

Moreover, Japanese investors sold a net 455.8 billion yen ($4.09 billion) of U.S. bonds in June, after selling a net 2.071 trillion yen in May, Japanese government data showed.

Holding U.S. Treasuries has become more expensive for Japanese and other overseas fund managers due to higher costs to hedge against the dollar.

A stronger domestic currency makes it less appealing to own U.S. bonds, although the dollar has rebounded from its broad weakness earlier this year.

Still, higher yields offered by U.S. bonds remain compelling for European and Japanese investors, analysts say.

The U.S. 10-year yield was almost 2.50 percentage points higher than comparable European yields and about 2.75 percentage points above its Japanese counterpart, Reuters data showed.

(Graphic: G5 10-year yields: reut.rs/2LjQMul)

CHINA’S “NUCLEAR OPTION”

Analysts said a solid August government refunding signals ample demand for Treasuries as domestic fund managers have stepped up purchases of U.S. government debt and foreigners bought more longer-dated Treasuries.

Last month, U.S. bond managers bought $92.05 billion of fixed-rate Treasuries issued by the government. This accounted for 54 percent of the total supply, which was the most ever.

Much of the increase in Treasury supply has been among short-to-medium-term maturities, which appeal to domestic buyers, analysts said.

A nagging worry, however, is whether Beijing would dump its bond holdings as retaliation in its trade conflict with Washington.

“China is holding its nuclear option. They can sell some of their U.S. debt holding,” Invesco’s Hooper said.

There have been no signs that China is slashing its Treasuries ownership since the Trump administration began imposing tariffs on Chinese imports in a bid to push the world’s second biggest economy to address its $375 billion trade surplus with the United States.

Chinese and U.S. trade officials will hold lower-level talks on Aug. 22-23.

It is unclear if U.S. mutual and pension funds, and banks and insurers, could keep pace with the increase in Treasury issuance if foreign demand continues to fall.

“We might have enough buyers today, but will we have enough four months from now?” Hooper said.

(Graphic: China, Japan Holdings of U.S. Treasuries: reut.rs/2DFLnLD)