Will the yuan’s slide zap China’s demand for Treasurys?

The rapid slide in the yuan, which has become increasingly correlated with other Asian currencies, could have wider implications on demand for U.S. Treasurys from the region, according to one market watcher.

“Aside from the Fed [Federal Reserve], the Chinese are the largest holders of Treasurys and whilst they have not been active buyers for some time, there is evidence that Asian currencies are increasingly correlated with the renminbi and less with the dollar,” David Keeble, global head of rates strategy at Credit Agricole wrote in a note on Wednesday.

“Thus, the depreciation of the CNY [traded onshore] and CNH [traded offshore] has wider implications for Treasury demand from the entire Asian central bank community,” he said, noting that in the recent years a significant portion of demand for Treasurys from Asian central banks have been in response to appreciation in their currencies against the dollar.

George Jurasek | E+ | Getty Images

George Jurasek | E+ | Getty Images

Keeble believes the yuan’s decline could squash the potential for any significant buying from the region to compensate for the reduction in purchases by the Federal Reserve.

(Read moreForeigners pare back on some US securities)

“It almost goes without saying that chances of large official buying from Japan with the yen so far from its highs is nil,” he added.

Japan, the second largest foreign holder of U.S. government debt, holds $1.18 trillion in Treasurys, a touch below China’s $1.27 trillion.

In December, China sold almost $48 billion worth of Treasurys – the most in two years – giving rise to speculation that the country’s appetite for the government debt could be waning.

Will China fall out of love with Treasurys?

Ju Wang, senior FX strategist, global research said if the People’s Bank of China successfully lowers expectations for further gains in the yuan it could reduce demand for Treasurys.

“If the central bank manages to lower appreciation expectations for the yuan, this could reduce speculative inflows into China, slow their FX reserves accumulation and hence lower their demand for U.S. Treasurys,” she said.

(Read moreIs China’s love for Treasurys waning?)

In the recent years, the yuan has been viewed as a one-way bet, giving rise to speculative inflows into the country.

The PBoC typically intervenes to contain appreciation in the currency by buying U.S. dollars, which often leads to buying Treasurys. For example, in the fourth quarter this intervention amounted to more than $2 billion per business day, according to RBS. Thus, lesser need for intervention could lead to less demand for U.S. assets.

Wang, however, says that if China were to slow its purchases it wouldn’t have a huge impact on the Treasury market. “In late 2011 and late 2012, China’s FX reserves accumulation slowed significantly. But look what happened in the U.S. Treasury market – yields touched historic lows,” she said.

Louis Kuijs, Chief Economist, Greater China at RBS says while the impact of a weaker yuan on China’s buying of Treasurys in the short-run remains unclear, the trend is towards lower demand over the longer-term.

“If the exchange rate regime changes and China stops intervening a lot in the FX markets, the buying of U.S. assets like Treasurys will come down. We know that the central bank is interested in moving towards a change in its monetary policy and exchange rate regime,” he said.

(Read moreIs China getting ready to widen the yuan’s band?)

Many strategists suspect that recent yuan weakness is a precursor to the next big change in currency policy – a widening of the yuan’s trading band – which is a step towards liberalizing the currency.

—By CNBC’s Ansuya Harjani. Follow her on Twitter @Ansuya_H

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