China decreased its holdings of U.S. government debt in April for the first time in 18 months, but this may not be the bearish signal it appears to be for U.S. Treasury bonds.

While the country's portfolio diversification means some pressure on demand for Treasuries, with spread products gaining some edge, analysts say a scenario of outright dumping of Treasuries is unlikely.

They believe China, who is accumulating foreign exchange reserves of $20 billion a month, would not want to threaten its own returns or risk driving its yuan currency rapidly lower against the euro and yen.

The Treasury Department's international capital (TIC) data for April released on Friday showed China's holdings fell by $5.8 billion to $414.0 billion, reflecting a net selling position for the first time since October 2005.

Where are they going to go with $1.2 trillion, what market can sustain it? William O'Donnell, head of U.S. interest rate strategy at UBS in Stamford, Connecticut, said referring to China's total currency reserves. We are looking at a diversification within dollars, into corporate bonds, agencies and mortgage based securities,

China is the second largest holder of U.S. Treasuries after Japan. As long as the reallocation is largely from one type of dollar asset to another, analysts say Treasuries and the U.S. currency should take this process in their stride.

They are moving away from the Treasury market, into higher yielding spread products such as corporate and agency debt. I would be loath to say one month makes a trend, said O'Donnell.

Last week, former Federal Reserve Chairman Alan Greenspan said there was little reason to fear a wholesale pullout by China out of U.S. Treasuries, adding the Chinese would not find a ready market for the securities.

Benchmark 10-year agency debt is yielding 40 basis points above 10-year Treasury notes, while Fannie Mae's 30-year note is yielding 6.21 percent, compared to the 30-year government bond's 5.23 percent.

CHANGES IN CURRENCY COMPOSITION KEY

The 10-year Treasury note yield has jumped from 4.60 percent at the end of March to 5.12 percent currently, after hitting a five-year high of 5.33 percent this month.

Yields were pushed higher by a combination of abandoned hopes of an interest rate cut by the Federal Reserve this year, fears of tighter credit conditions globally and mortgage-related selling.

Analysts said the only concern would be China shifting the currency composition of its reserves, a step they said would be difficult given the yuan's peg to the dollar.

If they shifted away from the dollar they would put pressure on the euro (to appreciate), pushing the dollar down and indirectly pushing their own currency down. There is a constraint on what they can do, said Brad Setser, research director at Roubini Global Economics in New York.

If China truly shifted the composition of its foreign reserves, that would be something to worry about and I don't think there is evidence that China has done so.

Analysts also cautioned that the TIC data were unreliable and should not be used to second-guess China's intentions regarding its massive reserves. April's figures were also likely distorted by the Easter holidays.

According to Setser, the TIC data undercounted Chinese purchases of Treasuries by about $90 billion from mid-2005 to mid-2006.

There is no reason to think that has changed. You cannot get a full picture of what China is doing by just looking at the TIC data. There are some things which are not appearing in the data as Chinese purchases. A lot of it is going through London, said Setser.

But data showed Britain's holdings of Treasuries fell to $134.2 billion in April from $146.6 billion in March.

The Chinese will continue to accumulate reserves for a long time and the best and safest place they can put them in is the US Treasury market, said Carl Weinberg, chief economist at High Frequency in Vahalla, New York.

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