When China announced a new array of stimulus measures earlier this month, this very important plan was overshadowed by China Premier Wen Jiabao’s concerns about the United States’ quickly growing debt load.

“We have lent a huge amount of money to the United States,” Premier Wen said. “Of course we are concerned about the safety of our assets. To be honest, I am definitely a little bit worried. I request the U.S. to maintain its good credit, to honor its promises and to guarantee the safety of China’s assets.”

China has cause to be concerned: As of December, the most recent figures available, China held $727.4 billion in Treasuries – about 26% more than the $578 billion in U.S. government securities the Asian giant held at the end of 2007. More than half of China’s nearly $2 trillion in foreign currency reserves are tied up in U.S. Treasuries and notes issued by other affiliated agencies of the U.S. government – including beleaguered mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE).

However, the value of U.S. Treasuries has dropped steadily since the government began selling record amounts of debt to finance its economic stimulus packages. Investors have lost an average of 2.7% in 2009, according to Merrill Lynch & Co. Inc.’s U.S. Treasury Master Index.

China’s leaders “are worried about forever-rising deficits, which may devalue Treasuries by pushing interest rates higher,” JP Morgan & Co. (JPM) analyst Frank Gong told The Associated Press. “Inside China there has been a lot of debate about whether they should continue to buy Treasuries.”

And as the U.S. debt soars as the government works to halt the worst financial crisis since the Great Depression, China’s concerns about this country’s growing deficits – and its creditworthiness – are escalating in kind.

Depending upon how it did so, were China to stop buying U.S. debt – or even worse, to start dumping it – the economic fallout could be widespread, and perhaps even catastrophic:

• The U.S. dollar would drop 15%-20%.
• U.S. stocks would get hammered.
• Inflation would spike and interest rates on Treasuries would jump into the 8% range.
• And the economy would end up flat on its back – where it would stay, with no rebound on the horizon.

Detailing the Deficit

During the first five months of the 2009 fiscal year, which began Oct.1, the U.S. budget deficit hit a record $764.5 billion. Last month, President Obama outlined a $3.94 trillion budget plan that would take the deficit to $1.75 trillion by the time the fiscal year ends Sept. 30. The plan then calls for a $1.17 trillion deficit for fiscal 2010.

As currently projected, the U.S. budget deficit is forecast to run at about 12% of gross domestic product (GDP) – even worse than the perennially anemic Japan, where the deficit is running at 11%. And the debt picture is certain to get worse.

The Treasury Department has the government’s printing presses running overtime just to finance the $787 billion stimulus passed by Congress earlier this year. And in order to pay for all the stimulus, bailout and fix-it plans that are being put in place to arrest the U.S. economic decline, the U.S. government is assuming a murderous amount of debt: Over the next decade, the Congressional Budget Office projects that the White House budget will run $9.3 trillion in deficits.

That’s $2.3 trillion more than the Obama administration had forecast. But even the CBO projection could prove way too low: It assumes that the U.S. economy – after declining 1.5% this year – will turn around an advance at a racy 4.1% clip in both 2010 and 2011, a forecast that seems far too rosy, given the depths that the U.S. economy appears to have reached.

And that brings us to China.

Enter the (Red) Dragon

During the past several years, government-operated “sovereign-wealth funds” (SWFs) from virtually every major economic powerhouse around the world had been on a global shopping spree, buying up assets and bidding up prices as they did so.

China was no exception.

So when worldwide financial-asset prices began to slide – and then to nosedive – China abandoned many of its riskier holdings, choosing to boost its stockpile of U.S. Treasury securities. That underscores one marketplace truism: Despite Premier Wen’s reservations, the market for U.S. debt is the only market large enough, liquid enough, and stable enough to accommodate China’s large-scale investments.

That’s forced China to engage in a kind of global investor activism – although, so far, most of that activism has been aimed at one country: The United States.

About one-fifth of China’s currency reserves were tied up in Fannie and Freddie debt last fall when the two mortgage firms were placed under government conservatorship, The Washington Post reported.

In fact, as Money Morning detailed back in September as part of its ongoing investigation of the bailout of the U.S. banking system, that U.S. government decision to take control of Fannie and Freddie was driven not by worries about the fading U.S. housing market, but by concerns that foreign central banks in China, Japan, Europe, the Middle East and Russia might stop buying our bonds.

China clearly made its risk concerns known at that time, adding to the sense of urgency U.S. officials felt to make a move. Today, as U.S. debt continues to mount at an obscene rate, financial and economic risks also escalate. This could lead to a spike in inflation and interest rates – a double-whammy that could cause any recovery that’s under way to sputter and stall. That duo of higher inflation and interest rates could also hammer bond values, including the Treasuries held in such large quantities by China. So it’s no wonder the risk concerns China articulated back at the time of the Fannie and Freddie takeovers go double or triple now.

Indeed, when Premier Wen unveiled the spending measures earlier this month, he made the point of saying that China should seek to “fend off risks” by further diversifying its reserves.

“We have already adopted a guiding management policy of diversifying our foreign exchange reserves, and at present our foreign exchange reserves are safe overall,” Wen said. “Our first principle in managing foreign currency is averting risk. We have always adhered to the principles of foreign currency security, liquidity and maintaining value, and implemented a strategy of diversification.”

When it comes to U.S. government debt, that strategy will take one of three forms, and will have the following potential effects:

1. Quietly threatening to stop purchasing (or even threatening to “dump”) U.S. Treasuries, a form of “back-channel” communications that can generate results (just look at how China forced the U.S. government to place Fannie and Freddie in conservatorship). Because this is back channel, it stays out of the marketplace, so long as the U.S. government finds some ways to appease Chinese investors by somehow reducing risk.

2. Quietly slowing or stopping its purchases of U.S. government debt. If China does this effectively and systematically, the fact that it’s cutting back on purchases doesn’t surface until the plan is executed. If China is able to pull this off – and it faces long odds to do so – the fact that it’s cutting back on U.S. debt doesn’t roil the markets too badly, especially if it doesn’t leak out until after the fact.

3. Publicly dumping U.S. debt. Self-explanatory in nature – and also the most unlikely, if it wants to maintain its “friendly” status with the United States – this is the worst-case scenario, and is the one that ends up with the dollar and the stock market getting stomped. If China chooses this route, it’s also essentially cutting off its nose to spite its face. The reason: By publicly dumping U.S. debt, the Treasury market will also take a beating – meaning China’s remaining U.S. debt holdings would take a haircut of 20% to 30%.

The Marketplace Realities

International demand for long-term U.S. financial assets actually fell in January, reflecting China’s smallest net purchase since May, Bloomberg reported.

International investors sold a net $8.4 billion in U.S. corporate debt in January, the report showed. Net foreign purchases of Treasury notes and bonds were a net $10.7 billion in for the month, after purchases of $15 billion a month earlier.

Few analysts believe China will abandon its Treasury holdings altogether, as that would hammer the dollar, hurt the value of its debt holdings and ruin its political relationship with the United States.

Besides, it’s becoming increasingly clear that Beijing wants a voice in Washington.

Yu Yongding, a former advisor to the Bank of China said last month that China should seek guarantees from the U.S. government that its holdings won’t be diminished by “reckless policies.”

Premier Wen echoed that request last week when he called on the United States to “honor its promises and guarantee the safety of China’s assets.”

“I think what they’re trying to say right now is, ‘Don’t take any steps that would impair our ability to access your market,’” Auggie Tantillo, executive director of the American Manufacturing Trade Action Coalition, told The Post. “The Chinese are starting to flex their muscles, they are becoming more powerful commercially and economically, and they want us to know it.”

The very possibility that China and other foreign countries would stop buying U.S. bonds already was enough to prompt the U.S. government to take control of foundering mortgage giants Fannie Mae and Freddie Mac.

Source: The Three Ways China May Deal With Growing U.S. Debt

But while Treasury prices hit record highs, concerns surfaced among analysts about how much farther the rally can go considering the implied message in the Fed’s statement that the economy is in worse shape than we thought and policy makers will do anything they can to keep it from completely tanking.

“Everyone originally was very enthused yesterday because the Fed made it known they were going to stand and do anything that is necessary, no matter what, to get this economy back on track,” said Sal Arnuk, co-manager of trading at Themis Trading in Chatham, New Jersey. “This morning we awaken with a hangover and the realization of how many bullets do they have left?”

Long term Treasuries with 10- and 30-year maturities were favored by investors after the Fed said it would keep long-term interest rates suppressed for “some time.”  In its statement the central bank vowed to buy agency and mortgage-backed securities and said it will consider purchasing government debt.

Yields on the 10- and 30-year notes tumbled in New York trading, touching their all time lows, according to BGCantor Market Data, as investors continued to bid up prices.

And for the second straight day, investors in the shortest government securities were willing to accept a negative return for the safety of U.S. government debt, as yields on one-month T-bills reached minus 0.02%.

But the Fed’s latest statement has raised doubts about its real intentions with some analysts.  Even though the central bank promised to purchase treasuries to keep interest rates from rising, policy makers will likely avoid purchasing government debt, according to RDQ Economics LLC.

“This step is still an unlikely one for the Fed to take, since it is trying to narrow the spread between mortgage-backed securities and Treasuries,” John Ryding and Conrad DeQuadros, founders of New York-based RDQ, wrote in a note yesterday.

30-year mortgage bonds issued by Fannie Mae (FNM) currently yield 1.49 percentage points more than the benchmark 10-year Treasury note, down from 1.62 percentage points Tuesday. The Fed wants to drive those yields down to encourage borrowers and lenders.

More skepticism comes from the rates themselves.  After all, how many investors can tolerate a negative return on their money, when the very nature of investing says they will eventually demand a respectable return?

History is another factor leading some investors to conclude that the Treasury rally is overdone because yields simply can’t fall much further.  For instance, the 10-year Treasury currently yields around 2.5%, despite an average of 6.91% since 1962.

Then there are those who see the Fed’s move to cut rates to virtually zero as validation of the market’s valuation of short-term credit.  Treasury markets had already breached the Fed’s previous Federal Funds target of 1% before Tuesday’s move to cut that target to 0% to 0.25%

“Short-term interest rates have been falling sharply since the financial markets went into a tailspin in September. With Tuesday’s announcement the Fed was essentially acknowledging that it can’t control interest rates any more,” said John Schoen a Senior Producer at MSNBC.

That may be speculation, but the Fed was indeed conspicuous by its absence in the open markets early Wednesday.

According to Reuters, the Federal Reserve of New York said the U.S. central bank had refrained from any open market operations on Wednesday. Typically the New York Fed conducts open market operations at 9:30 a.m.

The regional Fed conducts open market operations for the central bank system. The Fed normally supports its monetary policy by executing short-term purchase and reverse repurchase agreements to influence day-to-day trading in the Federal Funds market.

Federal funds, the benchmark overnight lending rate to banks, last traded at 0.0625%, within the Fed’s new target range of zero to 0.25%.
Source: Fed’s Zero Interest Policy Fuels Treasury Rally

On the other hand, the system components that monitor the Federal Reserve’s own stash of government bonds was loudly going “gong, gong, gong!”, as U.S. Government Securities Owned Outright went down another $22.3 billion last week, taking the Fed’s total down to $502 billion, which is itself down $220 billion from a year ago.

Quickly summarizing, in just a few weeks, a third of the Fed’s entire stash of government debt, accumulated bit by bit since the Fed was first authorized by a few Congressional conspirators on Christmas Eve, 1913, has been used up by the Fed trying to paper over its own horrific mistakes! Yikes! Ron Paul was right; we have to abolish the Federal Reserve!

Apparently, everybody is cheered that the new official, government-determined and government-sanctioned inflation is 3.9%, which makes me laugh to think that anybody in their right mind would believe that, and then which makes me howl in anger because the damned Federal Reserve and a willing co-conspirator Congress (except Ron Paul) allowed this to happen by allowing the banks to create so much excess money and credit, so astonishingly much excess money and credit, so stupidly and criminally irresponsibly much excess money and credit, for so many months, so many years and so many decades, which doesn’t even mention the fact that throughout all the rest of human history, 3% inflation was considered to be the cut-off between “High” and “Emergency! Emergency!”, but which is actually ignored today!

This brings up a laughable “letter to the editor” of the Financial Times from David Nowakowski of Atlas Management, who wrote, “For 25 years, the Fed has kept inflation at an average of 3.2 per cent a year – that should be applauded”! Hahaha! You will go a Long, Long Time (LLT) long time before you hear something so ridiculous! Hahahaha! Applauded! Hahahaha!

But even 3.2 percent sounds good right now, as even food and energy, and everything else we have to buy, are increasing at rates of inflation that are multiples of the “official rate”, which means that the horrifying 3.9% inflation is, unbelievably, the residual inflation after the government ignores the things that went up a lot in price, and then lies about the rest! Hahahaha!

My laugh is nervous and dry, and for a little comic relief we go to this week’s Barron’s and look in their “Indexes’ P/Es & Yields” table to see that the price-to-earnings ratio for the Dow Jones Industrial Average is now up to 87.07! This is, incredibly, up from last week’s P/E ratio of 85.97! Hahahaha!

And while that is funny enough, get a load of this; the dividends paid by the DJIA companies to their stockholders was $317.88, while earnings were only $149.16! Hahahaha!

Naturally, my stupid kids come running into the room with that very fact in hand, and they want to know why it is that the 30 companies in the Dow Jones Industrial Average can pay out three times as much as they earn, and yet I can’t let them have a tiny fraction of what I make with which to buy decent food, or shoes that are not held together with duct tape. My eyes narrowing, I pointedly ask them, “And who pays for the duct tape?” and they have to admit that I do. Naturally, I think this closes the whole point of discussion, and so I provide the denouement by saying, “So shut the hell up and go to hell!”, but they, of course, don’t.

So I ignore them, and since I am already in the “Indexes’ P/Es & Yields”, I take a look at the S&P500, and see that the P/E ratio there is 22.89, which is up from last week’s P/E of 20.89, even though earnings dropped to $62.28 from last week’s $66.28, which are both down from last year’s earnings of $83.39! Hahahaha!

This S&P 500 thing is oddly at odds, as oddly odd as that sounds, oddly oddly oddly, when we read, also in Barron’s, that Alan Skrainka of investment firm Edward Jones says that buying the stocks in the S&P500 index “is inexpensive”, as it is selling at (he says) a P/E of 14 times earnings, which is “based on a rolling 12-month estimate for the period ending next April”.

At first, I was struck by the metric “a rolling 12-month estimate for the period ending next April”. Initially, I wondered, like you, “What in the freaking hell is a ‘rolling 12-month estimate’, and how can I use it to advantage?”

That is why I am sitting in this bar, excitedly planning my next crucial move, but being distracted by the irritating bartender yelling at me to pay up, even though I keep explaining to this moron that when I said “Drinks on the house!”, I did NOT mean that I am “the house”, and I thought he was just being a nice guy for letting us drink free all afternoon.