U.S. Treasuries face test from China's yuan move

NEW YORK (Reuters) - The U.S. Treasury market may be vulnerable to a sell-off on Monday on fear that China's move to allow more flexibility for its currency means the world's largest holder of U.S. sovereign debt will cut future purchases.

Adding to market tensions, the surprise move on Saturday occurred before next week's sales of $108 billion in shorter-dated debt by the U.S. Treasury and a Federal Reserve policy meeting this week.

In July 2005 when China abandoned its peg against the U.S. dollar and moved to a managed float, there was a sharp sell-off in U.S. Treasuries, a reaction that some analysts say could happen again.

"The knee-jerk reaction was a 10 to 15 basis point increase in yields. That was one of the biggest moves of the year and it continued to rise for two to three weeks thereafter," said George Goncalves, head of U.S. interest rate strategy at Nomura Securities International in New York.

Other analysts said China's announcement, which lacks details, will have little impact on bond prices and next week's U.S. Treasury auctions, which consist of $40 billion in two-year notes, $38 billion in five-year debt, and $30 billion in seven-year notes, may be the focus instead.

They said China's latest currency move is part of a gradual process, which has not slowed its accumulation of U.S. Treasuries since 2005.

As of April, China held $900.2 billion in U.S. government debt, ahead of Japan, which owned $795.5 billion, the U.S. Treasury said this week.

"The message from the Chinese authorities is that they are resuming the journey toward greater, but still measured reliance on, market-based instruments -- a journey that was interrupted by the financial crisis and that involves gradually allowing greater exchange rate flexibility," said Mohamed El-Erian, chief executive and co-chief investment officer at PIMCO in Newport Beach, California.

PIMCO's $228 billion Total Return Fund, the world's biggest bond fund, raised its market value weighting in U.S. government debt to 51 percent at the end of May from 36 percent in the previous month.

Citing the slow rate of change, IFR analysts see little immediate market response, but agree that in the bigger picture the revaluation is a clear negative for Treasuries.

Trade between China and the United States will move toward balance and income, or dollar flows into China from the United States will diminish, reducing Chinese demand for Treasuries, IFR said.

China will likely invest more in its own economy as well as the rest of Asia, further diverting flows away from U.S. Treasuries, IFR said. But the true market impact is down the road in two to five years time.

The timing of China's announcement may embolden bond bears, who are still smarting from the safehaven rally tied to Europe's public debt crisis. The intensity and duration of a bond sell-off will likely hinge on the perception of how much more flexibility China will allow in the yuan, analysts said.

"If a revaluation is in the cards, in the weeks ahead the market could push toward 3.50 percent on the 10-year Treasury note. It could cheapen the market to a new equilibrium between 3.00 to 4.00 percent," Nomura's Goncalves said.

China's yuan announcement could stoke the appetite for stocks and diminish the appeal of bonds, as it raises hopes of more competitive priced U.S. goods overseas and profits for U.S. exporters.

On Friday, the 10-year Treasury yield ended at 3.23 percent in New York trading, far below the 4.00 percent peak it hit in early April.

China's participation at next week's debt auctions will serve as an early litmus test on its latest currency move.

"We'll take confirmation from the auctions that something is going on," said Christopher Low, chief economist at FTN Financial in New York.

...THEN THERE IS THE FED

The weekend yuan news should make a big splash on Monday, but traders could quickly turn their attention to the Fed's two-day policy meeting, which begins on Tuesday.

With consumer prices falling and unemployment remaining near 10 percent, it is difficult to imagine the Fed expressing worries over inflation or any intention to rescind its "extended period" promise to keep rates low.

Obviously any retreat or softening by the Fed in its low-rates commitment would hurt bonds, but one must also wonder whether the risk is now for an even more dovish statement given the apparent economic deceleration.

The Fed's statement is due at 2:15 p.m. EDT (1815 GMT) on Wednesday.

The Fed has stuck with a near zero interest rate policy since adopting it in December 2008. The debt troubles in Europe have led traders to push back the timing of a Fed rate hike toward the middle of 2011.

"It's hard to see how rates, especially in the shorter end of the curve, can move very far given the fundamentals, given the Fed outlook and a lot of what's going on the inflation outlook," said Bill Schultz, chief investment officer at McQueen, Ball & Associates in Bethlehem, Pennsylvania.

(Additional reporting by Jennifer Ablan and IFR Markets Global Managing Rates Analyst Kenneth Logan; Editing by Chris Wilson)