I don't see the Chinese doing anything that would damage the United States. It's in their interest - and in a way they're in bed with us as investors and savers.

The rise of Treasury rates, or yields, has been characterized as both good and bad omens. Various interpretations have been put forward. To wit:

• The rise of term Treasury rates reflects the improved outlook for real growth.
• The rise of term Treasury rates signals declining risk aversion and the unwinding of the safe haven inflows that occurred last fall.
• The rate rise demonstrates increased inflation expectations related to concerns of monetization of the burgeoning federal debt.
• The rise is evidence of decreased demand on the part of foreign investors.

These and possibly other explanations may all be factors in the market. I'm sympathetic to the good omen explanations—that the rise is connected to the improved outlook—but I don't rule out that there is something here to monitor very carefully. The steepening of the yield curve may reflect growing concern over the nation's ability to correct profound structural imbalances; that is, to combine recovery with transition.

For years, we have been able to finance a large share of our budget deficits with relatively cheap capital from abroad, and for years this has worked to our benefit. But our country should not regard international capital markets as a bottomless well. As access to this well becomes more limited, the cost of financing our fiscal deficits could rise.

[F]rom what I can detect from the activity of so-called indirect bidders in Treasury auctions—indirect bidders submit competitive bids through others rather than directly; central banks are among those who commonly bid indirectly—there continues to be strong demand for longer duration Treasuries—again, contrary to rumors and press reports. Thus, to date, our actions have not given rise to concern that we will violate Paul's Dictum.

[A shortage of Treasury securities] is not one of the things I'm worried about.

From audience Q&A as reported by Bloomberg News.

... I'm not particularly concerned about any major change in the holdings of China or any other country.

There is, on the margin, sovereign wealth funds and portions of reserve accumulations that are being devoted to higher return, which means spreading across instruments, as well as across currencies.

But again, I don't see any significant change in the broad holdings of dollars around the country -- around the world.  Dollars remains the dominant reserve asset and I expect that to continue to be the case.

I would like to add, though, that the strength of the dollar, in the medium term, will ultimately depend not on those portfolio choices, so much as on the strength of the U.S. economy, our trade situation and on the openness of our financial markets to foreign capital.

And I'm optimistic on those fronts. And I do believe that that will lead to a sound dollar in the medium term.

Bernanke said "there is no indication (the Chinese) are thinking of radically changing their composition of assets" and to back away quickly from their U.S. holdings would "not be in their interest." He added the threat of China moving away from U.S. assets is not "a significant risk."

As reported by Dow Jones News

Among these benefits is our ability to borrow from the rest of the world at a low interest rate. Between 1980 and 2005, for example, the income paid to foreigners who owned U.S. assets was 4.9 percent on average. However, the income paid to Americans who owned foreign assets was 6.3 percent. In other words, the United States effectively borrowed at a discount of 1½ percent.

Some people have argued that this spread partly reflects the fact that the United States tends to borrow from the rest of the world in the form of safe, relatively short-term government debt, and much of U.S. lending to the rest of the world is in the form of foreign direct investment or riskier, long-term debt. While there is truth to this claim, I think that most people would agree that at least part of the difference in returns on investment reflects a willingness by foreigners to pay a liquidity premium to hold assets denominated in U.S. dollars.

Beginning in July 2005, the Chinese government officially unpegged the RMB from the dollar, and, since then, the currency has appreciated by about 6%.  Chinese policymakers seem likely to allow this process of gradual RMB appreciation to continue, so long as it is slow and orderly.  Few people, however, believe that even a more substantial RMB appreciation would have much effect on China's overall trade balance. F or one thing, to the extent that China imports many components used in producing its export goods, an appreciation lowers the cost of those imports, offsetting somewhat the effect on export prices.  For another, demand for many Chinese exports tends to be fairly strong, regardless of price, which implies a limited trade response to an appreciation.  Most observers do not see China's trade surplus coming down until it ramps up government spending and domestic consumption, increasing its own demand for foreign imports.

To exert some control on slow and orderly movements in the RMB, the PBOC intervenes in the foreign exchange market, buying dollars with RMB that it issues. This intervention has resulted in the PBOC's accumulation of over $1 trillion in foreign reserve assets. Moreover, such intervention also swells the domestic supply of bank reserves. Therefore, to avoid inflation, the PBOC must offset the associated liquidity increase by sterilizing reserve inflows. It has accomplished this by issuing low-yield PBOC bills in open market operations and by progressively raising the reserve requirements of domestic banks. However, the policy of forcing low-yield PBOC bills on the banking sector works at cross-purposes with banking sector reforms, which are ultimately aimed at creating a banking sector that operates on a sound commercial basis.

I should first point out that it's not in the interest of China or Japan to dump treasuries on the market. They, themselves, would suffer capital losses from doing that.

I do think if there were -- and I should be very clear, I have not information or expectation this is going to happen. But if there were significant sales by foreign central banks, for example, that there would be some short-run effect on the market, in terms of the currency and interest rates probably.

I think the longer-term effect would be somewhat less because the market would adjust. It is a liquid market. And the holdings of, say, China of U.S. debt securities, including both public and nonpublic, is only about 5 percent of the total credit market outstanding.

Part of this recent dynamic in financial markets is a consequence of the present state of the international monetary system, in which a substantial part of the world economy runs exchange rate regimes tied in some way to the dollar. This has entailed a sustained period of very substantial official accumulation of dollar reserves, putting downward pressure on U.S. interest rates and upward pressure on U.S. asset prices.

These forces are surely transitory, but their impact on capital flows, interest rates and asset prices are important, not just in terms of their short-term impact on growth. If they are large enough, they have the potential to alter or distort current decisions about investment and consumption in a way that could be detrimental to our longer-run growth prospects. And they are important because they work to mask or dampen the effects on risk premiums in financial markets that we might otherwise expect to be associated with the expected trajectory of the fiscal and external imbalances in the United States.

"There is a mutuality of interests" between the United States and other countries that hold large amounts of U.S. dollar assets," Yellen said in response to an audience question following a lecture at the University of California, Irvine.

"But it doesn't mean it couldn't change. It could be the case where other countries channel less of it into dollar assets and eventually have an impact at some stage that we might have to address," she said.

As reported by Reuters News

... [T]he dramatic rise in the level of official reserves in much of the emerging world is not simply the consequence of a desire for a greater financial cushion against external vulnerability. It also results from the lingering aversion to letting exchange rates adjust upwards in response to market forces.

As capital markets become more open, this middle ground is harder to sustain. The broadening recognition of this is leading to a gradual increase in exchange rate flexibility, and this process is likely to continue. The pace of progress, progress in the direction of more openness to capital flows and greater exchange rate flexibility, will depend in part on the pace at which these governments are able to strengthen the resilience of the domestic financial system and set in place the broader institutional framework and supervisory regime that are vital for an open economy.

The fact that official purchases of financial assets are determined by different factors than those influencing private investors suggests that we would probably see a somewhat different combination of capital flows, exchange rates and interest rates in the absence of official intervention...

If the prevailing patterns of capital flows were to exert downward pressure on interest rates and upward pressure on other asset prices, they would contribute to more expansionary financial conditions than would otherwise be the case. Among other things, this outcome complicates our ability to assess the present stance of monetary policy. It can change how monetary policy affects overall financial conditions and the economy as a whole.

Such complications can mask the effect of other forces that might otherwise find expression in risk premiums or interest rates: forces, for example, associated with the concern about fiscal sustainability in the United States or the sustainability of our external imbalances...

A second possible explanation of the evident decline in the term premium is linked to the increased intervention in currency markets by a number of governments, particularly in Asia. According to this explanation, foreign official institutions, primarily central banks, have invested the bulk of their greatly expanded dollar holdings in U.S. Treasuries and closely substitutable securities, and these demands by the official sector have put downward pressure on yields. This interpretation has some support, including research that I did with two coauthors that found that longer-term yields came under significant downward pressure during episodes of heavy official purchases of dollars in 2004...

However, these observations speak more to the existence of a short-term impact of large purchases and sales--the result of limits to liquidity in the very short run--than to the perhaps more important question of whether those transactions have a lasting effect on yields.

A reasonable conclusion is that the accumulation of dollar reserves abroad has influenced U.S. yields, but reserve accumulation abroad is not the only, or even the dominant, explanation for their recent behavior.