What do new highs in U.S. Treasury bonds and new lows in Chinese bonds mean for Hong Kong stocks?

Abstract

Looking back over the past month, the market has once again exhibited the "high and then low" trend that has been frequently seen in recent years, returning to the starting point from a month ago. We indicated in late November that expectations for overly strong policies may still be unrealistic, and the market has not completely escaped the oscillating pattern, maintaining a strategy of entering at the low end and profiting on the excited right side. The performance over the past period has also confirmed this view.

Last week, the Federal Reserve's hawkish rate cut led to a rapid rise in U.S. Treasury yields and the U.S. dollar index, while domestic monetary easing expectations drove domestic rates significantly lower. We believe that new highs in U.S. Treasuries often correspond to tightening U.S. dollar liquidity, which exerts pressure on the valuation of Hong Kong stocks from the denominator side.

Even though new lows in Chinese bonds hedge against the rise in U.S. Treasuries from the denominator side, the numerator side reflects pressure on growth expectations. Therefore, overall, the combination of "new highs in U.S. Treasuries + new lows in Chinese bonds" has a neutral to slightly negative impact on Hong Kong stocks, as historical experience often suggests.

In summary, we still maintain the judgment of an overall oscillating pattern in the Hong Kong stock market for three main reasons: first, with the important domestic window period coming to an end, the market enters a policy vacuum period before the Two Sessions; second, external disturbances, especially the uncertainty surrounding the future path of the Federal Reserve, still exist.

However, technical indicators show that Hong Kong stocks are currently in a relatively neutral state, with the Hang Seng Index ERP, short-selling ratio, and RSI all at levels seen at the beginning of the rebound in late September. In this context, we recommend focusing on 1) supply clearance, 2) policy support, and 3) stable returns.

Looking ahead, external shocks, especially the varying scenarios of tariffs after Trump's inauguration, may determine market paths and domestic policy responses. 1) If tariffs are implemented gradually (initial tariffs of 30-40%), the expected impact on the market will be limited, and we suggest investors maintain current oscillating structure operations; 2) If the maximum tariff of 60% is imposed, the market may face significant disturbances. However, we believe this could provide better buying opportunities.

Main Text

New highs in U.S. Treasuries and new lows in Chinese bonds

Market Trend Review

Affected by the Federal Reserve's hawkish stance leading to a significant rise in U.S. Treasury yields and the U.S. dollar index, as well as domestic economic data falling short of expectations, the Hong Kong stock market weakened again last week.

In terms of indices, the Hang Seng Index and MSCI China Index fell by 1.3% and 0.9%, respectively, while the Hang Seng Tech and Hang Seng China Enterprises Index dropped by 0.8% and 0.6%. Sector-wise, telecommunications services (+4.0%) and media entertainment (+2.1%) showed resilience, while traditional sectors like real estate (-5.1%) and materials (-3.8%) lagged behind.

Chart: Last week, the MSCI China Index fell by 0.9%, with real estate and materials sectors under the most pressure.

 Source: FactSet, China International Capital Corporation Research Department

Market Outlook

Looking back over the past month, the market has once again exhibited the "high and low" trend that has been frequently seen in recent years, returning to the starting point from a month ago.

In late November, with the approach of important meetings such as the Politburo meeting and the economic work conference, the market's positive expectations for policy heated up, temporarily pushing the market higher. However, we pointed out at that time that overly strong expectations may still be unrealistic, as the market has not completely escaped the oscillating pattern, maintaining a strategy of entering at the low end and profiting on the excited right side.

The reason for this judgment is that the market at its current position has already factored in relatively sufficient expectations. For further upward movement, more policy support, especially fiscal policy, is needed. However, under "real constraints" such as leverage levels, financing costs, and exchange rates, we believe that overly high expectations in the short term are unrealistic.

The actual situation indeed confirms our view, as the market's performance over the past period has largely validated our perspective.

The positive signals conveyed by the Politburo meeting, such as "extraordinary counter-cyclical adjustments" and "moderately loose" monetary policy, drove the market to rise rapidly. However, after fully digesting expectations, the limited incremental information on some market concerns (such as the intensity of fiscal stimulus and consumption subsidies) during the economic work conference, along with expressions of "strengthening regulation" on platform economy that exceeded expectations [1], triggered a market pullback, with the Hang Seng Index basically returning to the level at the end of November.

Chart: Hang Seng Index risk premium returns to the early rebound level at the end of September

Source: EPFR, Wind, China International Capital Corporation Research Department

As the important domestic window period gradually passes, external shocks, especially the Federal Reserve's hawkish interest rate cuts, have also become a source of volatility in global markets, including Hong Kong stocks, last week.

At the December FOMC meeting, compared to the already fully anticipated interest rate cuts, the updated "dot plot" expects only two rate cuts in 2025. Coupled with Powell's continuous emphasis on a more cautious pace of future rate cuts, this hawkish statement immediately triggered market fluctuations, with the 10-year U.S. Treasury yield quickly rising to nearly 4.6%, reaching a new high since the end of May this year.

The U.S. dollar index has climbed to its highest level since the end of 2022. In stark contrast, the warming expectations for domestic monetary easing and the cooling of fiscal strength have driven domestic interest rates to fall sharply, with the 10-year China government bond yield once breaking through the 1.7% mark, and the 1-year China government bond even dropping below 1%, leading to a widening of the China-U.S. interest rate spread to historically extreme levelsSo, what impact does the combination of "new highs in U.S. Treasuries + new lows in Chinese bonds" have on Hong Kong stocks?

► New highs in U.S. Treasuries: Tightening U.S. dollar liquidity exerts pressure on Hong Kong stock valuations from the denominator side. The most direct impact of rising U.S. Treasury yields alongside a strengthening U.S. dollar is the tightening of overseas liquidity. Historically, in this context, overseas funds tend to weaken, and Hong Kong stocks, as an offshore market, are naturally more affected.

At the same time, rising U.S. Treasury yields will also influence the valuation pricing of Hong Kong stocks from the denominator side. Even considering that the current proportion of mainland funds in Hong Kong stock transactions can reach about 25-30%, when calculating the risk-free rate for Hong Kong stocks, we use a 7:3 weight of U.S. Treasuries to Chinese bonds. The changes in U.S. Treasury yields still dominate, so their rapid increase in the short term will also exert pressure on Hong Kong stock valuations from the denominator side.

► New lows in Chinese bonds: Hedging against rising U.S. Treasuries from the denominator side, but reflecting growth expectation pressure from the numerator side. Conversely, the rapid decline in Chinese bond yields driven by expectations of monetary easing seems to offset some of the adverse effects brought by rising U.S. Treasury yields on the denominator side.

However, the rapid decline in yields also implies market expectations of weak domestic growth in the future. Therefore, although there is some support from the denominator side (but not as significant as the impact on A-shares), it brings greater pressure from the numerator side in terms of growth expectations.

Thus, overall, the combination of "new highs in U.S. Treasuries + new lows in Chinese bonds" has a neutral to slightly negative impact on Hong Kong stocks, which is often the case based on historical experience.

Reviewing the impact of changes in the China-U.S. interest rate differential on the Hong Kong stock market over the past five years, we find that during periods when "U.S. Treasuries rise + Chinese bonds fall," leading to a widening China-U.S. interest rate differential, the valuation of Hong Kong stocks has been significantly under pressure for most of the time, often accompanied by an overall outflow of overseas funds from the Chinese stock market.

Chart: "New highs in U.S. Treasuries + new lows in Chinese bonds" often have a neutral to slightly negative impact on Hong Kong stocks.

Data source: EPFR, Wind, China International Capital Corporation Research Department

That said, we believe investors need not be overly pessimistic, and we still maintain our judgment of an overall oscillating pattern in the Hong Kong stock market.

First, regarding the future path of the Federal Reserve, although more time is needed for observation, we still judge that interest rate cuts can occur later. The market's excessive short-term expectations often lead to overcorrections, and the reflexivity of interest rates and financial conditions to the fundamentals allows the current "hawkish" stance to provide space for future "cuts."

Secondly, technical indicators also show that Hong Kong stocks are currently in a relatively neutral state, such as 1) the Hang Seng Index risk premium (ERP) is currently around 7.4, which is roughly equivalent to the level at the beginning of the rebound at the end of September2) The short selling turnover ratio on the 5th has retreated from 17.3% at the end of November and has maintained around 15.5%, close to the level before the market rebound in late September this year; 3) The Relative Strength Index (RSI) on the 14th also fell from the previous week's high of 59.9 to a median level of 47.1. At the same time, the Hang Seng Index is also basically at important support levels on both daily and monthly charts around 19,500.

Therefore, under the assumption of moderate and limited domestic policy efforts, the current oscillating structure remains our baseline scenario, and the short-term market may remain stagnant at this position, but it can also go up or down.

Chart: The short selling turnover ratio is currently around 15.5%

Source: Bloomberg, CICC Research Department

Chart: From the perspective of overbought and oversold levels, the current Hong Kong stocks are also at a neutral level

Source: Bloomberg, CICC Research Department

Looking ahead, as the market enters a policy vacuum period before the Two Sessions, external shocks, especially the different scenarios of tariffs after Trump's inauguration, will determine the market path and domestic policy responses. 1) If tariffs are implemented gradually, for example, an initial tariff of 30-40%, which means an additional 10-20% on the current level of 19%, we expect limited impact on the market.

This level basically aligns with the current market consensus expectations, and its actual economic impact is relatively controllable. The market's reaction at that time may be more similar to the third round of tariffs in April 2019, where there were disturbances but maintained range-bound oscillation. The current risk premium in A-shares is also roughly equivalent to the levels in April-May 2019. In this scenario, we recommend that investors maintain the current oscillating structure operations;

1. Conversely, if a maximum tariff of 60% is imposed, due to insufficient market pricing and the actual impact becoming non-linear, the market may face significant disturbances. However, if there is indeed a large fluctuation at that time, it could provide better buying opportunities, not only because valuations are cheap but also due to a higher probability of policy hedgingIn addition to external disturbances, the economic data for November also shows that domestic fundamentals need further policy support to boost them.

In November, the total retail sales of consumer goods increased by 3% year-on-year, a decrease of 1.8 percentage points compared to October, falling below market expectations. Although factors such as e-commerce platforms advancing the "Double Eleven" promotional activities have had an impact, if we focus on the year-on-year growth rate of non-trade-in goods from October to November, it is only 3.2%, which is at a low point for the year, indicating that endogenous consumer demand remains weak.

At the same time, real estate development investment has dragged down overall fixed asset investment from a year-on-year growth of 3.4% from January to October to 3.3% from January to November. In our report "Hong Kong Stock Market Outlook 2025: Cloudy but No Rain," we pointed out that to address the current domestic credit contraction and the private sector's ongoing "deleveraging" issue, it is necessary to lower actual financing costs.

We estimate that a further reduction of 40-60 basis points in the 5-year Loan Prime Rate (LPR) could help bridge the gap between financing costs and investment returns, but the Federal Reserve's slowing pace of interest rate cuts and exchange rate pressures may constrain the room for further easing in the short term;

On the other hand, from the perspective of more effectively boosting investment return expectations, we estimate that a "one-time" and "new" broad expenditure of 7-8 trillion yuan may be needed to close the output gap accumulated over the past three years (implying a growth rate of around 9%), which still falls short of the currently known scale (the general public budget deficit rate raised to around 4% corresponds to 1 trillion yuan, plus 2 trillion yuan for debt relief).

This means that incremental stimulus will occur, but overly high expectations may not be realistic.

Therefore, in this context, we maintain our judgment of a structurally fluctuating market overall. In terms of allocation, under the assumption of an overall fluctuating pattern, we recommend focusing on three types of industries:

First, sectors where supply and policy environments have been sufficiently cleared, where marginal demand improvements would be even better, such as certain consumer services in the internet sector, home appliances, textiles and apparel, and electronics. Second, policy-supported directions, such as home appliances and automobiles under trade-in policies, as well as trends in the autonomous technology fields like computers and semiconductors; third, stable returns, such as high dividends from state-owned enterprises.

Specifically, the main logic supporting our above views and the changes to focus on this week include:

1) November's retail sales in China fell short of expectations, and real estate development investment dragged down fixed asset investment.

Overall, the economic data for November was weak, and although the effects of the trade-in policy continue to manifest, endogenous demand remains weak. In November, the total retail sales of consumer goods increased by 3% year-on-year, a decrease of 1.8 percentage points compared to October. This year, e-commerce platforms further advanced the "Double Eleven" promotional activities, which accelerated retail sales growth in October but correspondingly overdrawn demand in November.

The growth in retail sales was mainly driven by the trade-in policy for consumer goods. The macroeconomic team at CICC calculated that the year-on-year growth rate of retail sales for trade-in goods in November was 8.2% (compared to 8.9% in October), maintaining a high growth rate. However, the year-on-year growth rate of non-trade-in retail sales from October to November was 3.2%, which is at a low point for the year, indicating that endogenous consumer demand has not improvedAt the same time, fixed asset investment from January to November increased by 3.3% year-on-year (3.4% from January to October), with real estate investment still being the main drag, while broad infrastructure and manufacturing investment grew relatively steadily [2];

Chart: Domestic data in November overall trended weakly, with retail sales falling short of expectations, and real estate development investment dragging down fixed asset investment.

Source: Wind, CICC Research Department

2) In December, the Federal Reserve FOMC cut interest rates by 25bp, but the expectation for rate cuts in 2025 was reduced to 2 times. At the December FOMC meeting, the Federal Reserve announced a 25bp rate cut, lowering the benchmark interest rate to 4.25-4.5%, in line with market expectations. However, compared to the fully expected rate cut, the Federal Reserve conveyed a more hawkish signal regarding future rate cut pace, suggesting that the pace of future cuts may slow down.

1. The "dot plot" expects only two rate cuts in 2025 (3.75-4%), fewer than the market's expectation of three;

2. In the meeting statement, the Federal Reserve slightly added wording considering "magnitude and timing," indicating that future rate cuts may slow down;

3. Powell also continuously hinted at a potential slowdown in the pace of future rate cuts during the press conference, stating that the current policy has significantly eased due to the 100bp cut since September (now significantly less restrictive), and that future actions will be more "cautious" (be more cautious) and will move slower (moving slower) [3];

3) The U.S. November PCE price index was lower than expected. The U.S. November PCE price index increased by 2.4% year-on-year (vs. 2.3% in October), although it is the highest level since July this year, the increase was below the expected value of 2.5%. Month-on-month growth was 0.1%, also lower than the expected value of 0.2%.

Excluding food and energy prices, the core PCE in November increased by 2.8% year-on-year, which also fell short of the expected value of 2.9%. The overall November data being below expectations also indicates a slowdown in price pressures, and after the data was released, the U.S. dollar index and 10-year U.S. Treasury bonds both weakened significantly;

4) Outflows of overseas active funds expanded, while passive funds turned to inflows, and southbound capital inflows accelerated. EPFR data shows that as of December 18, the outflow of overseas active funds from the Chinese stock market expanded to USD 700 million (vs. USD 480 million outflow in the previous week), marking 10 consecutive weeks of outflowsOverseas passive funds have once again turned to inflows of $1.55 billion (vs. an outflow of $230 million in the previous week). Meanwhile, southbound capital inflows have accelerated compared to the previous week, increasing from an inflow of HKD 21.12 billion to an inflow of HKD 25.89 billion.

Chart: Overseas active fund outflows expand, southbound capital accelerates inflow

Source: EPFR, Wind, CICC Research Department

Authors: Liu Gang S0080512030003, Zhang Weihang, Wang Muyao, Wu Wei, Source: Kevin Strategy Research, Original Title: "CICC | Hong Kong Stocks: New Highs in US Bonds and New Lows in Chinese Bonds"

Risk Warning and Disclaimer

The market has risks, and investment requires caution. This article does not constitute personal investment advice and does not take into account the specific investment objectives, financial situation, or needs of individual users. Users should consider whether any opinions, views, or conclusions in this article are suitable for their specific circumstances. Investing based on this is at one's own risk