Led by China, foreign countries dumped U.S. Treasury bills at a record rate in December, which could signal a rise in interest rates to make the bills more attractive to investors. The interest rate rise which could be the beginning of an inflationary period.  According to the Treasury Department 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.

The move triggered concerns about China’s continuing appetite to loan money to the U.S. amid a mounting budget deficit here and tensions between Washington and Beijing.

China pared its Treasury holdings by $34 billion to $755.4 billion in December, placing it second behind Japan, with $768.8 billion, according to U.S. Treasury estimates. For the first time since August 2008, Tokyo took over the top spot after steadily increasing its purchases of Treasury debt over the past several years.

Policy makers, economists and others have long worried about what would happen if China tired of its role as a key creditor to the U.S., which continues to borrow record sums amid the economic downturn.

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It seems as if we will soon learn what will happen if China gets tired of being our banker.  And still our government looks to spend more and drive us further in debt/

A sustained drop in foreign demand for dollar-denominated assets could lead to higher U.S. interest rates and falling stock prices. Those trends could threaten the U.S. recovery. But economists said they see no such evidence yet.

Alan Meltzer, an economics professor at Carnegie Mellon University, said China’s shift should be a wake-up call for Washington.

“The Chinese are worried that we have unsustainable debt levels, and we do not have a policy for dealing with it,” Meltzer said.

He said the Chinese worry that confidence in the U.S. government’s ability to repay its debt could erode. That would cause the value of Treasurys and the dollar to fall — and lead to losses on Beijing’s’ U.S. debt holdings.

The Obama administration on Feb. 1 released a budget plan that projects the deficit for this year will total a record $1.56 trillion. That would surpass last year’s record of $1.4 trillion deficit.

The recession helped drive up the deficits. Tax revenue fell as the economy slowed. And spending undertaken to support the economy and stabilize the financial system worsened the budget gaps.

The administration has pledged to address the budget gaps. President Barack Obama has said he will appoint a commission to recommend ways to trim future deficits. But China and others have expressed doubts about the commitment of the United States to reduce the red ink.

Obama and his progressive majority plans to cut the gap with tax hikes, which will slow down/reverse any recovery and lead to lower tax revenue generation.

Chinese officials have become increasingly vocal about Washington’s need to tame the budget deficit. The assistant finance minister last year said the Chinese “sincerely hope the U.S. fiscal deficit would be reduced, year after year.” In March, Premier Wen Jiabao expressed “worries” over China’s significant holdings of U.S. government bonds. Those holdings mean China’s national rainy-day fund is mainly driven by factors out of its control, such as fluctuations in the value of the dollar and changes in U.S. economic policies.

Moody’s Investors Service has warned that the U.S. government’s top credit rating could be jeopardized if the nation’s finances don’t improve. Asked about this report, Treasury Secretary Timothy Geithner said this month he was confident the United States “will never” loose its sterling credit rating. He predicted foreigners would keep buying U.S. Treasurys as a safe investment.

Lets not forget that Geithner also said his tax returns were done correctly.

“China may not be too happy with us right now, but you have to ask, what else are they going to do with their money?” said David Wyss, chief economist at Standard & Poor’s in New York.

Sounds like a great marketing campaign.  Buy our stuff, we suck less than the other guys.

Ted Truman, a former Federal Reserve official now at the Peterson Institute, noted that while the holdings China shed represent a record one-month sum, it’s a “drop in the bucket” compared with China’s overall holdings.

Some economists said China’s selling was cause for modest concern but noted it occurred before the recent sovereign-debt worries in Europe, prompted by fiscally strapped Greece and concerns over the pace of the global economic recovery. Those concerns have pounded the euro and driven many investors back into the relative safety of U.S. Treasury debt.

“With all of these cracks in the euro zone, if you’re a reserve manager, are you going to feel great about buying reserve euros right now?” said Win Thin, senior currency strategist at Brown Brothers Harriman. “It looks like the U.S. is better positioned.”

Whether its the start of something bad, or its just an alarm, either way its should be a signal to Congress to cut the budget and do it NOW!