CITIC Securities Co., Ltd.: Beware of the volatility risk of the long-term U.S. Treasury yields caused by the tax reduction bill

According to the Zhitong Finance APP, CITIC Securities released a research report stating that Moody's downgraded the U.S. rating on May 16 local time due to the continuous expansion of the U.S. deficit, increasing debt interest, and declining U.S. debt affordability. Following this downgrade by Moody's, there was a brief period of significant volatility in U.S. stocks and bonds at the market opening on May 19, but subsequent speeches by U.S. government officials and Federal Reserve officials calmed market sentiment. Although the volatility caused by the downgrade of the U.S. debt rating has subsided, it is still necessary to remain vigilant about the risks of fluctuations in long-term U.S. Treasury yields due to tax reduction proposals, tariffs, and fluctuations in the U.S. economy.

Moody's stated that the main reason for the downgrade of the U.S. debt rating is the expansion of the U.S. deficit, while future debt interest expenditures are also expected to increase, and the U.S. debt affordability is declining.

Unlike S&P and Fitch's dissatisfaction with the last-minute resolution of the U.S. debt ceiling issue, the background for Moody's downgrade of the U.S. debt rating on May 16 (local time) is the rise in U.S. Treasury yields since 2021, which has led to a decline in U.S. debt affordability. Additionally, if the Trump tax cut proposal successfully passes Congress, it will further exacerbate the pressure on the U.S. deficit. Moody's expects the U.S. federal deficit to widen, reaching nearly 9% of GDP by 2035, up from 6.4% in 2024. Following the downgrade, the U.S. lost its AAA sovereign debt rating from all three major rating agencies.

Furthermore, on the evening of May 19 local time, Trump's large-scale tax cut proposal passed the House Budget Committee vote and may be passed by the House this week. If the bill is signed after passing Congress, it will exacerbate the fiscal pressure on the U.S.

The Trump tax cut proposal includes policies that will increase the U.S. deficit, such as the permanent reduction of personal income tax, extension of estate tax exemptions, and increased child tax credits, as well as spending cuts like reducing Medicaid, reforming the university endowment tax and student loans, eliminating clean energy tax credits, and imposing a 5% tax on remittances from illegal immigrants. The U.S. Joint Committee on Taxation estimates that by 2034, this proposal will increase the deficit by $3.8 trillion (1.1% of GDP). Moody's also pointed out that if the 2017 tax cut proposal is extended (its baseline forecast), the federal government's main deficit will increase by about $4 trillion over the next decade.

Looking back at the history of U.S. ratings, S&P and Fitch downgraded the U.S. rating in 2011 and 2023, respectively, mainly due to the decline in the U.S. debt governance capacity and the risk of fiscal deterioration.

In August 2011, S&P downgraded the U.S. sovereign debt rating just days after Congress passed the Budget Control Act and raised the debt ceiling. The trigger for this downgrade was that year's debt ceiling crisis, with S&P believing that the fiscal consolidation plan reached by Congress and the government was insufficient to stabilize medium-term debt dynamics, and the political deadlock highlighted the increasing instability, inefficiency, and unpredictability of U.S. governance and policy-making. In August 2023, Fitch downgraded the U.S. rating based on the judgment of future fiscal deterioration. The background was the bipartisan agreement reached in June of that year to suspend the debt ceiling until January 2025, while President Biden signed the bill just days before the "X date" (June 5) Fitch pointed out that despite reaching an agreement, the governance level of the U.S. government has continued to decline, particularly in the areas of fiscal and debt management, with recurring political deadlocks over the debt ceiling and agreements reached at the last minute undermining market confidence in fiscal management.

After S&P and Fitch downgraded the U.S. debt rating in 2011 and 2023 respectively, both U.S. stocks and bonds experienced certain negative impacts.

Historically, sovereign rating downgrades have a more significant short-term suppressive effect on U.S. stocks, with negative impacts lasting about 1-2 weeks; while long-term U.S. Treasury yields are affected more briefly, with no significant sustained increases in either instance, possibly due to the downgrades occurring after the resolution of the U.S. debt crisis, and after the U.S. debt rating was downgraded, market risk aversion drove funds into the U.S. Treasury market, which in turn pushed U.S. Treasury yields down to some extent.

After Moody's downgraded the rating, there was a significant short-term fluctuation in U.S. stocks and bonds at the market opening on May 19, but subsequent remarks from U.S. government officials and Federal Reserve officials calmed market sentiment.

Unlike the previous two rating downgrades that occurred after the resolution of the debt ceiling crisis, this downgrade is set against the backdrop of the ongoing advancement of the Trump tax cut plan and persistently high U.S. policy interest rates. On the evening of May 18, the House Budget Committee passed the Trump tax cut plan, and if the plan is signed into law, it will further worsen the U.S. fiscal situation, exacerbating market concerns about the fiscal deficit, which in turn led to a noticeable increase in long-term U.S. Treasury yields after the market opened on May 19. However, on that day, U.S. government members and Federal Reserve officials made concentrated statements to stabilize market sentiment, causing Treasury yields to retreat after rising. Although the volatility triggered by the current rating downgrade has subsided, it is still necessary to remain vigilant about the risks of fluctuations in long-term U.S. Treasury yields due to the tax cut plan, tariff policies, and fluctuations in the U.S. economy