Risk-free U.S. Bonds at Risk: China’s Diversification Strategy and Moody’s Downgrade Draw a Red Line

TradingKey - Just days after the easing of global trade tensions due to the Trump administration's tariff truce, the U.S. Treasury market may be facing further pressure — with no rally in sight. The recent bond market weakness has been exacerbated by two major developments: China’s decline as the second-largest holder of U.S. debt, and Moody’s downgrade of U.S. sovereign credit, which stripped America of its last AAA rating.

In the week that the U.S. and China reached the Geneva trade agreement on May 12, U.S. equities surged — the S&P 500 gained over 5% across five consecutive session , while tech stocks like NVIDIA (NVDA.US) and Tesla (TSLA.US) rose 16% and 17%, respectively. As risk-off sentiment eased, demand for safe-haven Treasuries weakened, pushing the yield on the 10-year U.S. Treasury back above 4.5% — for the first time in three months.

Following April’s “Treasury selloff,” two new developments may now be triggering another U.S. bond crisis.

On May 16, Moody’s downgraded the United States’ sovereign credit rating from Aaa to Aa1, marking the loss of the final AAA rating from a major global rating agency. Fitch and Standard & Poor’s had previously downgraded U.S. sovereign credit in 2023 and 2011, respectively.

Moody’s cited concerns that the U.S. government’s debt and interest payment levels have risen far beyond those of countries with similar credit ratings. It warned that large fiscal deficits could further deteriorate U.S. public finances.

According to the U.S. Treasury’s report released on May 16, China’s holdings of U.S. Treasuries dropped from $784 billion in February to $765 billion in March, while the UK increased its holdings by $30 billion to $779 billion during the same period. This marks the first time since October 2000 that China’s U.S. Treasury holdings have fallen below those of the UK, making China the third-largest foreign holder of U.S. debt.

As reported by the Financial Times, this move highlights a shift in China’s foreign exchange reserve management strategy — reflecting a broader effort to gradually reduce reliance on U.S. assets and pursue portfolio diversification.

The U.S.-China "Rebalancing"

As U.S. Treasury Secretary Scott Bessent explained, the Trump 2.0 administration’s series of policies — including tariffs — aims to address the persistent U.S. trade deficit that has existed for nearly 50 years, seeking to rebalance the macroeconomic imbalance where the U.S. has long relied heavily on Chinese excess production capacity through excessive consumption.

For decades, the U.S. has sustained economic growth under a system fueled by “twin deficits” — both fiscal and current account deficits.

On one hand, the dollar’s dominant role in global finance and strong U.S. consumer demand have enabled the U.S. to import massive volumes of goods and services, accumulating significant trade deficits.

On the other hand, the U.S. government has issued large amounts of debt to attract global capital inflows, funding ever-expanding fiscal expenditures — though still falling short of covering all costs.

This model has been supported in the short term by the dollar’s privileged status, but in the long run, it erodes the foundation of the U.S. economy — much like maxing out a credit card. If repayment capacity cannot keep up, the borrowing-based model will eventually collapse.

The April Treasury selloff was driven precisely by such concerns. As Trump’s tariff policy continued to swing unpredictably, global investors began questioning the stability of U.S. policymaking, the credibility of the U.S. government, and the sustainability of its fiscal path, leading to a broad sell-off of dollar-denominated assets.

China is not alone in reducing its exposure. Brazil, India, and other emerging economies are also cutting their U.S. Treasury holdings. Some economists suggest that this trend toward foreign exchange reserve diversification is likely to continue.