China and the Footsteps of Doom

DEATH, in Terry Pratchett's discworld series, always shows up just when a character faces his or her inevitable end. Yet the character is always surprised and is never prepared for what in retrospect is obvious.

The news today from the New York Times that China is concerned about its holdings of U.S. Treasuries has this flavor. China's own difficulties, its inevitable discomfort with the financial abyss facing the United States and the sheer size of its treasury holdings made this moment inevitable. Yet as Bloomberg notes

President Barack Obama is relying on China to sustain buying of Treasuries amid record amounts of debt sales to fund a $787 billion stimulus package.

Good luck. As the NYT piece notes

. . . much of the Treasury debt China purchased in recent years carries a low interest rate, and would plunge in value if interest rates were to rise sharply in the United States. Some financial experts have warned that measures taken to combat the financial crisis — running large budget deficits and expanding the money supply — may eventually create price inflation, which would lead to higher interest rates.

This puts the Chinese government in a difficult position. The smaller the United States stimulus, the less its borrowing, which could help prevent interest rates from rising. But less government spending in the United States could also mean a slower recovery for the American economy and reduced American demand for Chinese goods.

So where does the U.S. go if the Chinese start to get cold feet? Keep a close eye on treasury yields.