June 1 (Bloomberg) -- For all the hand-wringing over the dollar’s slide, the expanding U.S. deficit and the nation’s AAA credit rating, the bond market shows international demand for American financial assets is as high as ever.

The Federal Reserve’s holdings of Treasuries on behalf of central banks and institutions from China to Norway rose by $68.8 billion, or 3.3 percent, in May, the third most on record, data compiled by Bloomberg show. The Treasury said bidding from foreigners was above average at its $101 billion of note auctions last week.

U.S. government securities have tumbled 4.3 percent so far this year, the worst performance since Merrill Lynch & Co. began tracking returns in 1978, as so-called bond vigilantes drove up yields to punish President Barack Obama for quadrupling the budget shortfall to $1.85 trillion. The purchases by foreigners show that, at least for now, there’s little chance of buyers abandoning the U.S. or threatening the dollar’s status as the world’s reserve currency.

“The U.S. Treasury market is the widest, deepest, most actively traded market in the world,” said Jeffrey Caughron, an associate partner in Oklahoma City at The Baker Group Ltd., which advises community banks investing $20 billion of assets. “There’s really no other game in town.”

Dollar Index

Concerns about international investors have grown as the U.S. Dollar Index weakened 8.6 percent since February and Obama and Fed Chairman Ben S. Bernanke committed $12.8 trillion to thaw frozen credit markets and snap the longest U.S. economic slump since the 1930s. About 51 percent of the $6.36 trillion in marketable Treasuries are held outside the U.S., up from 35 percent in 2000, according to data compiled by the government.

Goldman Sachs Group Inc., one of the 16 primary dealers required to bid at the Treasury’s debt auctions, estimates that the U.S. may borrow a record $3.25 trillion this fiscal year ending Sept. 30, almost four times the $892 billion in 2008.

“There’s an awful lot of Treasury issuance going on,” said Michael Moran, the chief economist at Daiwa Securities America Inc. in New York. “In the back of everyone’s mind there’s a realization that although the short-term fiscal situation is difficult, so too is the long-term situation. People are looking down the road, seeing budget deficits remaining wide and they are thinking the U.S. possibly can lose its AAA rating.”

Treasury Secretary Timothy Geithner, in an interview with Bloomberg Television May 21, said the administration’s goal is to cut the budget deficit to 3 percent of gross domestic product or smaller. That would be down from a projected 12.9 percent this year.

China’s ‘Worried’

Geithner arrived in Beijing yesterday with a pledge to control borrowing as he sought to reassure China its holdings of U.S. government debt are safe. “No one is going to be more concerned about future deficits than we are,” he told reporters on the way to two days of meetings in China’s capital.

Chinese Premier Wen Jiabao said in March that the country was “worried” about its investment and wanted assurances the value of its holdings would be protected.

“I hope Geithner’s visit can soothe our nerves,” said Yu Yongding, a senior researcher at the government-backed Chinese Academy of Social Sciences and a former central bank adviser. “The Chinese public is worried about the safety of its foreign- exchange reserves,” Yu said in an e-mail.

Seventeen of 23 Chinese economists surveyed in connection with Geithner’s visit said Treasuries are a “great risk” for the economy, according to a Chinese state media report yesterday. Still, the majority argued against quickly cutting them, the Beijing-based Global Times reported.

Increased Holdings

China increased its holdings by 3.2 percent, the most since November, buying Treasuries with its reserves to control the level of the yuan. The currency, which was pegged at about 8 to the dollar until July 2005, has traded between 6.8 and 6.9 since last June. It closed May 29 at 6.8291 to the dollar.

“To some extent they have to buy Treasuries because they want to support their currency peg,” said Carl Lantz, an interest-rate strategist in New York at Credit Suisse Securities USA LLC. The firm is also a primary dealer.

Bond investors have driven up the yield on the benchmark 10-year Treasury note, which helps set rates on everything from mortgages to corporate bonds to as high as 3.75 percent last week from the record low of 2.035 percent in December. A rally at the end of the week pushed the yield on the 3.125 percent note due in May 2019 down to 3.46 percent.

Bond Vigilantes

The yield on the 3.125 percent note due May 2019 rose six basis points to 3.53 percent as of 7:10 a.m. in New York, according to BGCantor Market Data. A basis point is 0.01 percentage point.

Rising rates can be attributed to the “bond vigilantes,” according to Edward Yardeni, who came up with the phrase in 1983 when he was chief economist at Prudential to describe investors who protest monetary or fiscal policies they consider inflationary by selling bonds.

The term covers “really anybody who owns a bond that gets disillusioned and starts to worry about the value of their investment, if the government runs huge structural deficits and there are growing concerns that may lead to higher inflation,” said Yardeni, who is now head of Yardeni Research Inc. in Great Neck, New York.

Record Sales

The government is selling record amounts of bonds to repair the damage from the collapse of the subprime mortgage market in 2007. Credit markets froze last year, Lehman Brothers Holdings Inc. collapsed in September and the world’s largest financial institutions reported $1.47 trillion of writedowns and losses, Bloomberg data show.

Bernanke’s efforts to reduce the premium consumers pay for credit compared with government borrowing costs succeeded this year as the gap between 30-year fixed mortgage rates and 10-year Treasuries narrowed to 1.77 percentage points last month from 3.05 percentage points in December.

The gains are in jeopardy as the vigilantes drive up interest for everyone. The average rate on a typical 30-year fixed mortgage rose as high as 5.27 percent last week from 4.85 percent in April, according to North Palm Beach, Florida-based Bankrate.com. Credit cards average 10.4 percentage points more than one-month London interbank offered rate, up from 7.19 percentage points in October.

Fed Officials

Fed officials see several possible explanations for the rise in yields. One is the outlook for the economy is improving and investors are selling government debt used as a hedge against mortgage securities.

Another is the supply of Treasuries for sale exceeds the Fed’s so-called quantitative easing program. After cutting its target interest rate for overnight loans between banks to almost zero, the central bank pledged to buy as much as $300 billion of Treasuries and $1.25 trillion of bonds backed by mortgages to cap borrowing costs.

Bernanke hasn’t formally asked policy makers to consider whether to increase Treasury purchases and may not do so before the Federal Open Market Committee’s next scheduled meeting June 23-24. Officials are confident they can mop up excess cash without gaining additional tools from Congress.

Concern over rising budget deficits is also showing up in the currency market. The dollar index, which tracks the greenback against the euro, yen, pound, Swiss franc, Canadian dollar and Swedish krona, dropped 4.9 percent in May, the biggest drop since December. The euro strengthened 7 percent and the pound appreciated 9.5 percent.

‘Negative’

Declines accelerated after Standard & Poor’s lowered its outlook on the U.K.’s AAA credit rating on May 21 to “negative” from “stable,” raising concern it may do the same to the U.S. because of a rising debt load.

S&P said last week the change in the U.K.’s outlook “is not a secret message to Washington.” The U.S. deficit is 7.8 percent of gross domestic product, compared with what Chancellor of the Exchequer Alistair Darling estimates will be 12.4 percent for the U.K. Moody’s Investors Service said May 27 the U.S. rating is stable “even with a significant deterioration” in the debt burden.

“Treasuries are still a buy and you can’t explain that from the macro economic perspective alone,” said Mickael Benhaim, who manages about $32 billion as head of global bonds at Pictet & Cie Banquiers in Geneva. His fund began increasing its position in Treasuries last week. “I see U.S. Treasuries as attractive because we are still in the middle of quantitative easing and that will continue to cap yields.”

Demand for Treasuries was evident last week at the government’s sales of two-, five- and seven-year notes.

Auction Results

Indirect bidders, a group that includes foreign central banks, purchased 54.4 percent of the $40 billion in two-year notes sold May 26, the biggest percentage since November 2006, according to the Treasury. They bought 44.2 percent of the $35 billion five-year notes auctioned May 27, compared with an average of 32.4 percent at the previous 10 sales. The scooped up 33 percent of the $26 billion of seven-year notes offered on May 28, matching the average of the other three sales this year.

“The idea that we have lost sponsorship at the auctions seems farfetched,” said Ian Lyngen, an interest-rate strategist in Greenwich, Connecticut at RBS Securities Inc., another primary dealer.

Below Average

The rate on the 10-year note is still below the average of 6.49 percent over the past 25 years, and will likely stay below 4 percent through at least the third quarter of next year, according to the median estimate of 50 economists surveyed by Bloomberg. The Dollar Index is 13 percent above its record low level of 71.314 reached in July 2008. The greenback will appreciate against the euro and yen through the end of 2010, a separate survey showed.

The dollar is supported by investors betting the U.S. economy will strengthen as America recovers first from the global economic recession.

Confidence among U.S. consumers jumped in May by the most in six years, according to the Conference Board’s sentiment index. Manufacturing in the Philadelphia region contracted in May at the slowest pace in eight months as shipments and employment improved, the Philadelphia Fed reported.

Those who expect the recession to continue say the currency should benefit as the haven from turmoil in world markets.

‘Fully Aware’

“Investors who are holding Treasuries are fully aware they are facing risks of yields rising and the dollar weakening but they have few other choices,” Stephen Lewis, the chief economist at Monument Securities Ltd., a London-based brokerage.

At the end of 2008 the dollar accounted for 64 percent of all central bank reserves, up from 62.8 percent in June 2008, according to the International Monetary Fund in Washington.

The U.S. has the “enormous privilege of controlling the world’s most important reserve currency,” allowing it “to borrow almost without limit,” Moritz Kraemer, S&P’s head of sovereign ratings for Europe, Middle East and Africa, told reporters at a media briefing in Johannesburg on May 27. There is no “serious contender” to threaten the dollar’s status as a global reserve currency, he said.

To contact the reporters on this story: Daniel Kruger in New York at dkruger1@bloomberg.netSusanne Walker in New York at swalker33@bloomberg.net.

Last Updated: June 1, 2009 07:40 EDT