Moody's Downgrade Prompts Hong Kong Funds to Reevaluate U.S. Treasury Bonds

In a significant development, the downgrading of the United States' credit rating by Moody's has sparked concerns among Hong Kong fund managers regarding their holdings of U.S. Treasury bonds. Under the Mandatory Provident Fund (MPF) system, funds with a total asset value of 1.3 trillion Hong Kong dollars (approximately 166 billion U.S. dollars) are only permitted to invest more than 10% of their assets in U.S. Treasury bonds if they are rated AAA or equivalent by recognized rating agencies. Following Moody's downgrade, only the Japanese Credit Rating Agency (R&I) maintains this rating for the U.S.

This situation has prompted the Hong Kong Investment Funds Association to convey the concerns of fund managers to the MPF Schemes Authority and the Financial Services and the Treasury Bureau. The association has suggested that the authorities consider making an exception for U.S. Treasury bonds, allowing funds to continue investing in these assets even if their rating falls below AAA. This move underscores the potential risk the U.S. faces in complying with Hong Kong's stringent investment regulations. Most global investors do not require the highest rating for investing in U.S. Treasury bonds, which mitigates the risk of forced sales.

By the end of 2024, the total assets of MPF bond funds and mixed asset funds that may hold U.S. Treasury bonds are estimated to be 484 billion Hong Kong dollars. The MPF Schemes Authority has confirmed that the U.S. still qualifies for special treatment as it retains the highest credit rating from one recognized agency. The Financial Services and the Treasury Bureau, along with the MPF Schemes Authority, have stated that they will closely monitor market developments and take appropriate actions to safeguard the interests of MPF scheme members. The Hong Kong Investment Funds Association has not responded to inquiries.

Moody's decision to downgrade the U.S. credit rating on May 16 was driven by the rising U.S. Treasury yields since 2021, which have increased the country's debt burden. Additionally, the potential passage of Trump's tax cuts could further exacerbate the U.S. fiscal deficit. Moody's projects that the U.S. federal deficit will widen to nearly 9% of GDP by 2035, up from 6.4% in 2024. This downgrade has resulted in the U.S. losing its AAA sovereign debt rating from all three major rating agencies.

Traders are increasingly betting on a surge in long-term U.S. Treasury yields due to concerns over the U.S. government's expanding debt and deficit, with Trump's tax cuts adding to the uncertainty. Reports indicate that major Wall Street strategists, including those from Goldman Sachs and JPMorgan, are raising their yield forecasts, with significant bets placed on the 10-year U.S. Treasury yield reaching 5%. The potential impact of this situation on U.S. Treasury bonds remains a critical area of concern.

Historically, sovereign rating downgrades have had a more pronounced short-term impact on U.S. stocks, with negative effects lasting about 1-2 weeks. Long-term U.S. Treasury yields have shown only brief reactions to such downgrades, possibly due to the timing of the downgrades relative to the resolution of U.S. debt crises and the subsequent flight to safety in U.S. Treasury bonds. However, the current context, with Trump's tax cuts progressing and U.S. policy rates remaining high, presents a different scenario. The passage of the tax cuts could further deteriorate the U.S. fiscal situation, increasing market concerns about the fiscal deficit and driving up long-term U.S. Treasury yields. While recent market volatility has subsided, ongoing risks related to tax policies, tariffs, and economic fluctuations could continue to impact long-term U.S. Treasury yields.

Additionally, there are concerns that foreign countries could retaliate against U.S. tariffs by selling their holdings of U.S. Treasury bonds. Although recent tariff tensions have eased, the possibility of further escalations remains. Given the massive size of the U.S. Treasury market, individual countries lack the capability to manipulate it. Historical data suggests that foreign sales have a lesser impact on U.S. Treasury yields compared to fundamental economic factors. However, if multiple countries coordinate a sell-off in response to tariffs, the impact on the U.S. Treasury market and global financial markets could be significant.