If money talks, then US$1.5 trillion shouts. That’s the value of China’s holdings in U.S. Treasury debt, in many analysts’ estimations. But the loud message coming out of Beijing now is that China won’t continue to buy and hold U.S. government debt in the way it recently has.

This new policy, even if it’s slow to be implemented, will have major consequences, not just for U.S. bonds but for Canadian debt markets as well. The implication is that your clients’ fixed-income portfolios should have their long-bond holdings reduced — especially if those bonds are U.S. Treasury issues.

China and other holders of large quantities of U.S. debt have a lot to worry about. There is no prospect in sight that the U.S. government will reduce the deficits that those bonds finance. Indeed, U.S. federal government debt will easily match the country’s gross domestic product in 2010.

China has recognized that Treasury bonds created to finance the rescue of the financial system in 2008 and 2009 will have to be devalued if the real assets they buy — U.S. goods and services — do not expand as fast as the supply of money. Moreover, the U.S. Treasury’s US$12-trillion (and still climbing) rescue package substitutes federal debt for degraded private-sector debt. The implications of this swap cannot be ignored.

A shift away from T-bonds is already evident. The rise of the price of gold this past autumn reflects increasing government purchases of the precious metal by India, China and European central banks. Those banks prefer to hold more of their assets in a form that is not being devalued by the massive issuance of credit to the U.S. banking system. Of course, China cannot swiftly abandon U.S. debt; doing so would clobber the value of the bonds it holds. Those same bonds, mostly T-bonds with 10 years to maturity, are among the most widely held around the world.

“[China is] slowly diversifying away from the U.S. dollar and U.S. debt,” says Patricia Croft, chief economist with Royal Bank of Canada’s global asset-management division in Toronto. “[But] China knows that if it told the world it is no longer buying U.S. debt, the U.S. economy would go into a downturn.”

And such a downturn would undoubtedly reduce the demand for Chinese goods and impact the nation’s incredible GDP growth rate.

But no matter how slowly China makes its moves, the markets will anticipate them, says Camilla Sutton, currency strategist with Scotia Capital Inc. in Toronto: “Markets are so forward-looking that they incorporate long-term values into short term-values.”

The alternative is that China will buy real assets and debt in other currencies, suggests Randy LeClair, senior vice president and global bond portfolio manager with Portland Investment Counsel Inc. in Burlington, Ont.: “Then, the U.S. will have to find new lenders or reflate the economy with a lower-valued dollar.”

This decision to abandon support of the greenback would rapidly reduce the value of U.S. bonds, LeClair points out. It would tend to raise the prices of strategic assets sought by the Chinese government as well as of corporate debt that might have higher credit ratings than U.S. government debt.

A sell-off of U.S. T-bonds would result in a cut to their prices and a rise in their yields. If the U.S. were to add reflation (via currency depreciation) to the mix, your clients would be well advised to add inflation margins to their calculations.

Central banks would see the steepening of their yield curves at hand and make their standard move of raising short-term rates. That would cause an inversion of the yield curve as short rates rise above mid-term rates, LeClair says. The implication, he adds, is to go short and ride up rising yields. His warning: stay away from long bonds.

For now, China’s moves to reduce its US$ holdings are being executed delicately, says Toronto-based credit-rating agency DBRS Ltd., noting in an Oct. 28 report that China was selling low-yield, short-term debt and adding to higher-yield, long-term holdings. The Bank of England and the Bank of Japan have made similar trades, the reports adds. In the short term, these moves raise returns; in the long run, they increase duration and portfolio risk.

If China takes money from U.S. T-bonds and invests it in European debt, Canadian gold mines or U.S. railways, the effects will be the same: U.S. bond prices will fall while the other financial assets China buys will go up in price. The astute move will be to buy into the trend, acquiring real assets whose prices tend to rise with inflation rather than falling in value as financial assets do, explains Vivek Verma, vice president with Canso Investment Counsel Ltd. in Richmond Hill, Ont.

@page_break@China could also shift from government debt to corporate bonds. As a large investor, China will want liquidity and depth; it will focus on large-cap companies’ bonds, giving relatively little attention to small issues from small companies. Beneficiaries of these moves would tend to be holders of long bonds from non-U.S. issuers with stable or rising currencies, such as Australia, Brazil, New Zealand and Canada.

“[Canada] has better fundamentals than the U.S., but our long government bonds have outperformed U.S. Treasuries,” Verma notes. “Part of the reason is the inflation outlook is better here than in the U.S.”

A critical question for Canadian bond investors is: will Ottawa have to follow Washington’s policy?

“It is difficult to imagine that 10-year U.S. Treasuries would yield 7% and Canadian 10-year federal bonds would yield 4%,” says Tom Czitron, managing director and head of income and structured products with Sceptre Investment Counsel Ltd. in Toronto.

If you think U.S. yield rates will be pushed up by China’s selling, then Canada bonds’ yields would also be pushed up. Canada bonds may outperform U.S. Treasuries, but only by losing less against other currencies. It’s a significant concern for long-term bond investments, he says.

But China’s restraint in selling U.S. bonds will keep the market orderly, suggests the DBRS report. The consequences for T-bills and bonds with only a few years to maturity are going to be negligible. That debt will mature at face value, regardless of what the greenback may suffer in foreign-exchange markets.

But anyone buying long bonds would have to consider the consequences of a bond market in which the value of the US$ has been eroded and is no longer the world’s dominant reserve currency. The U.S. will no longer be able to export its inflation and fiscal problems to the rest of the world.

The alternative to U.S. government debt is U.S. corporate debt, as well as U.S. or other debt priced in euros or other currencies. Some institutional investors with mandates to hold U.S. T-bonds will be unable to trade out of US$-denominated or -sourced debt. But your clients can do it easily by buying suitable bonds or investing in bond portfolios that avoid US$ pricing.

The easiest way is to build or buy ladders of bonds that can ride the inevitable trend of rising interest rates on U.S. and Canadian debt. This cuts long-term risk and leaves cash available as bonds mature, Verma says. Finally, you can consider corporate bonds with a few hundred basis points of spread over T-bonds, he adds: “When you have that spread, you have some protection.” IE