An economy facing possible indigestion from big increases in tariffs now is contending with a second headwind: potential fallout from a rise in government borrowing costs. Earlier this week, Moody’s downgraded the United States’ credit rating, stripping the United States of its Aaa rating. This downgrade is more than a technical market event; it represents an emerging consensus that the United States’ mounting debt burden has shifted from an abstract risk to a strategic constraint on U.S. power and leadership.
If the tax bill increases the deficit, the government will have to sell more bonds to plug the gap between spending and revenue. And that, in turn, means sustained higher interest rates. The Congressional Budget Office forecast that the GOP tax bill would push deficits to around 7% of gross domestic product in the coming years, an unprecedented amount of borrowing for a peacetime economy with a low unemployment rate.
On the flip side, the tax bill could provide about $280 billion in stimulus next year, or around 0.9% of GDP, mostly because of lower taxes. That would largely offset the possible hit from higher tariffs on imports. While the bond market did not like the message – pushing 30 year treasury yields above 5%, the stock market took it to mean that recession has been averted and economic growth will continue despite the tariffs.
For the week, the S&P 500 index retreated 2.6%. The Nasdaq slipped 2.5%, and the Dow also shed 2.5%.
Future Wealth’s View
Libraries are groaning from the weight of books written on the impact of rising deficits but fiscal discipline refuses to arrive in Washington. Treasury Secretary Scott Bessent has stressed his focus on keeping the 10 year Treasury yield down given how many corporate and consumer borrowing costs are tied to longer dated yields. But, basic economics tells us that rising deficits go against lower yields. To fund the deficit, the government will have to issue more bonds at higher and higher interest rates to make it attractive to bond buyers. The current interest payments on US debt is ~$1 trillion on ~$6 trillion in annual tax revenues. It is safe to say that that percentage is only going to get higher in the coming years.
Keynesian economic theory states that deficit spending could be beneficial during economic downturns. But Keynes emphasized that debt should be cyclical, not structural. Governments should run surpluses during economic expansions to pay down debt accumulated during downturns. It is clear no one in Washington is paying attention to quaint theories from a century ago. What is clear to us is that, left unaddressed, the compounding effects of deficits may fundamentally reshape how both allies and adversaries assess U.S. credibility and resilience.
For investors, the risk is that bond yields could rise to levels where bonds become more attractive than stocks. But, yields are rising for the wrong reason – due to fears of deficits and rising inflation instead of a strong economy. And the stock market is dismissing the same signals that the bond market is wary of. At some point, we could see a massive rotation away from equities to bonds and that will likely result in another stock market correction. We are not there yet, but imprudent fiscal policy may get us there sooner than we think.
As the saying goes – “A crisis always feels far off until you’re in one”.