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If you want to understand how China is affecting the U.S. bond market, watch what it does, not what it says.

Chinese officials have in recent months positioned themselves as sharp-eyed critics of U.S. fiscal deficits and unconventional monetary policy. Given that China holds perhaps $750 billion in U.S. government debt, many market watchers have become obsessed by the possibility that China could act on its worries about rising inflation and a falling dollar, and sell bonds.

But this grandstanding is really for domestic consumption, and obscures the hard facts of the U.S.-China financial relationship. As long as China continues to both run a trade surplus and control its currency by buying up the dollars generated by that surplus, it has little choice but to park the proceeds in U.S. Treasurys.

And there is no evidence that the rise in U.S. bond yields over the past few weeks has been caused by China paring its massive holdings. Federal Reserve data show foreign central banks added about $69 billion to their holdings of Treasurys in May.

The rise in bond yields mostly reflects a receding fear of deflation, as global commodity prices rise and signs of economic improvement accumulate. The market in Treasury Inflation Protected Securities is now pricing in inflation around 2%, roughly the same as it did last August before global output declined sharply.

It is in expectations for inflation that China's influence is really being felt. Its manufacturing surveys have turned into positive territory well before those in the developed world. Perhaps more importantly, China is gobbling up commodities: Net imports of copper have more than doubled so far this year. Iron ore imports are already a third higher than last year's record levels.

Yet China has made no secret of the fact that it has been taking advantage of lower prices to build up reserves of oil and metals. If that stockpiling falls off in coming months, and isn't matched by a pickup in real demand from developed nations, current expectations for rising commodity prices might start to look stretched. And then China could get blamed for bond yields coming right back down again.

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Andrew Batson

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