Where does stimulus money come from?

NEW YORK (Fortune) -- It's no secret that the government is borrowing huge sums of money. What may surprise you is how much of it is coming from the United States.

Rising domestic demand for U.S. debt allowed the government to sell more than $1.7 trillion of Treasurys during fiscal 2009. Those sales paid for billions of dollars of stimulus spending, without drawing unusually large contributions from overseas creditors such as China or triggering a long-feared interest rate spike.

The big question is whether the feds can pull off that trick again in 2010.

The government can't count on the Federal Reserve to soak up $300 billion of Treasurys, as it did last year in a bid to ease the stressed credit markets.

Even so, most analysts forecast a slow, prolonged rise in interest rates as markets adjust to a flood of global debt issuance, rather than a debilitating spike. Global economic growth remains wan, they note, and the financial shocks of the past two years haven't been forgotten - which tends to boost demand for income-generating bonds.

"For now, there's a savings response that you get after you have a financial panic, and then you get people trying to get a sense of what the new financial situation is," said Derek Scissors, a research fellow at the Heritage Foundation who studies trade with China. "That means domestic demand is probably sustainable for another year or so."

U.S. households bought up $374 billion of Treasurys during the fiscal year that ended Sept. 30, making them the second-biggest buyer after foreign governments, according to Fed data.

The bulk of those purchases came in the first quarter of 2009, as investors scrambled to salvage portfolios wrecked in the market meltdown of late 2008.

"That's people having the daylights scared out of them," said Scott Colyer, who runs broker-dealer Advisor's Asset Management in Monument, Colo. "People saw what happened with Lehman and ran from corporate bonds and money markets and everything else."

Colyer and others expect domestic flows into Treasurys to slow as the economy improves - though that alone needn't upset the marketplace. Stronger economic activity should give the government more tax receipts and reduce the need for further stimulus spending.

Even if the economy doesn't snap back, the days in which Americans saved nothing and spent all their income on stocks, houses and whatever was on sale at Costco are over - which should mean more money for bond investments.

U.S. taxable bond funds received nearly $300 billion of net inflows in 2009, according to Investment Company Institute data. The personal savings rate rose above 4% last year after years at negligible levels.

The Treasury has continued to find buyers at low interest rates even as China, a big purchaser of U.S. debt in recent years, seems to be not buying as much lately. China's official holdings have held steady since hitting $800 billion in May.

Yet long-term interest rates have risen only slightly since then, Scissors notes. He says this suggests China's role in bankrolling U.S. deficit spending has been overstated.

"The simple point is people need to stop worrying so much about China," he said.

Of course, there is plenty else to worry about.

Money managers such as Colyer warn that most government bonds don't look attractive now, given the likelihood of inflation down the road. Some critics even dispute the government data on who has been buying Treasurys, contending the official figures imply stronger demand than actually exists.

Among those selling has been Bill Gross of the giant bond investor Pimco in California, who built a huge position in government debt during the early stages of the crisis before turning bearish on U.S. government debt.

"The days of carefree check writing leading to debt issuance without limit or interest rate consequences may be numbered for all countries," Gross wrote on Pimco's web site this month.

Indeed, many say the enormous sums being borrowed by governments around the world will drive interest rates up in coming years, regardless of who's buying.

Unless the world sinks into Japan-style stagnation, borrowers are going to have to compensate their lenders for the risk of getting repaid down the road in dollars with less purchasing power.

"There is going to be demand for Treasurys, but the government is going to have to pay more to get deals done," Colyer said. "Common sense says we should expect higher interest rates in the future."