Are We Headed for a Debt Debacle?

two stories from FT:

Foreign demand for US Treasury securities fell by a record amount in December as China purged some of its holdings of government debt, the US Treasury department said on Tuesday.
China sold $34.2bn in US Treasury securities during the month, the US Treasury said on Tuesday, leaving Japan as the biggest holder of US government debt with $768.8bn. China overtook Japan as the largest holder in September 2008.
The shift in demand comes as countries retreat from the “flight to safety” strategy they embarked on upon during the worst of the global economic crisis and could mean the US will have to pay more to service its debt interest.
For China, the shedding of US debt marks a reversal that it signalled last year when it said it would begin to reduce some of its holdings. Any changes in its behaviour are politically sensitive because it is the biggest US trade partner and has helped to finance US deficits.
Alan Ruskin, a strategist at RBS Securities, said that China’s behaviour showed that it felt “saturated” with Treasury paper and that this is the sign of a trend. The change of sentiment could come at the detriment of the US dollar and the Treasury market as the US has to look to other countries for financing. Japan and the UK could pick up some of that slack and last month both added to their Treasury holdings. However, the overall monthly sell-off of $53bn was the biggest on record.

Fed governor's warning:

The US must fix its growing debt problems or risk a new financial crisis, Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, warned on Tuesday, adding a mounting deficit could spur inflation.
Mr Hoenig said that rising debt was infringing on the central bank’s ability to fulfil its goals of maintaining price stability and long-term economic growth. “Stunning” deficit projections were putting political pressure on the Fed to keep interest rates low, infringing on its independence at the risk of inflation, he said.
“Without pre-emptive action, the US risks its next crisis,” Mr Hoenig said in a speech at the Pew-Peterson Commission on Budget Reform.
He was the only Fed member who dissented at last month’s meeting against language indicating that interest rates should remain near zero for an “extended period”.
On Tuesday he said that the worst option for the US was a scenario where the government “knocks on the central bank’s door” and asks it to print more money. Instead, the administration must find ways to cut spending and generate revenue. He called for a “reallocation of resources” and noted that the process would be painful and politically inconvenient.
The US budget deficit is projected to be $8,000bn (€5,800bn, £5,000bn) in the next decade. Barack Obama, US president, recently lifted the government’s borrowing authority to $14,300bn.
If the Fed succumbed to pressure to increase the money supply, Mr Hoenig said, inflation would lead to a loss of confidence in the dollar and in the economy. Meanwhile, a potential stalemate between the fiscal and monetary authorities that govern the economy could allow growing imbalances to go unchecked, thus raising the costs of borrowing and of capital for the US.
The hawkish Kansas Fed president also warned against “dire” consequences of the central bank prolonging its holdings of mortgage-backed securities, which it purchased in an effort to prop up the US housing market. Mr Hoenig painted a picture of a slippery slope, where a less independent Federal Reserve was asked to find ways to support other ailing sectors, such as agriculture.
The Federal Reserve is purchasing $1,250bn in MBS through March. Mr Hoenig said that it must shrink its balance sheet as quickly as possible while being careful and systematic.
Being pulled into the political framework has complicated the Fed’s job, which Mr Hoenig said should remain focused on the Fed funds rate and price stability.
Holding tightly to the notion of Fed independence, he rejected a suggestion published in a paper by Olivier Blanchard, chief economist at the International Monetary Fund, that central banks should set higher inflation targets. He also said he hoped to avoid political pressure to restore quantitative easing policies.
“That’s when independence will be more important than ever,” he said.

from AP:

WASHINGTON (AP) -- A record drop in foreign holdings of U.S. Treasury bills in December sent a reminder that the government might have to pay higher interest rates on its debt to continue to attract investors.
China reduced its stake and lost the position it's held for more than a year as the largest foreign holder of Treasury debt. Japan retook the top spot as it boosted its Treasury holdings.
The Treasury Department said foreign holdings of U.S. Treasury bills fell by a record $53 billion in December. That topped the previous record drop of $44.5 billion in April 2009.