By Randall W. Forsyth

It wasn't a lost weekend, after all.

Tariff-pocalypse was averted after the U.S. and China stepped back from their threatened triple-digit import fees, sending stocks exuberantly higher early this past week. Equities seemed to lose some of their initial enthusiasm as the week wore on, but it was still their best in more than a month.

The bond market's mood was darker. Treasury yields rose past significant mileage markers as the 10-year benchmark note topped 4.5% and the 30-year long bond approached 5%. More important, those risk-free returns threatened to breach levels that had historically hurt the stock market. While bond yields backed off slightly from those levels, there remained a distinct air of disquiet in the debt market.

That may be traced to the Trump administration's other signal initiative, the so-called big, beautiful bill to extend the 2017 tax cuts due to expire at year end along with an array of other goodies promised in last year's presidential campaign. The rub is that the BBB, to use the measure's initials, is utterly incompatible with AAA, the top credit rating to which the U.S. Treasury clings. Only Moody's Investors still accords Uncle Sam its best grade, while the other major credit raters, Standard & Poor's and Fitch Ratings, previously demoted him one notch.

The BBB, as marked up by the tax-writing House Ways and Means Committee and rejected by five House Republicans this past week, points to even greater federal budget deficits than what's currently in place. The bond market, charged with funding those deficits, seems discomfited by the prospect.

The Joint Committee on Taxation estimated that the bill, including the renewal of the Tax Cut and Jobs Act of 2017, would increase deficits by $3.8 trillion through 2034, equal to 1.1% of gross domestic product. If the BBB were extended permanently, the Bipartisan Policy Center estimated that the deficit would be $5.3 trillion higher, or 1.5% of GDP, even including some $2 trillion in spending cuts through 2034. Based on the behavior of recent Congresses, that seems the more likely bet. Even before these expanded future deficits, the U.S. government is running up red ink at an annual rate of $2 trillion, or close to 7% of GDP -- a level unprecedented except for recessions or wartime.

Those projections may be optimistic. According to the Penn Wharton Budget Model, the bill would increase the "primary" deficit by $6 trillion over 10 years. The so-called primary deficit excludes interest costs, focusing only on spending on programs. But as noted here ad nauseam, the government's interest expense is the fastest-growing part of the budget, especially as old notes and bonds sold during the ultralow-interest-rate era following the 2008-09 financial crisis are refinanced with the current 4% coupons. Debt service now is a bigger burden than the military, which has marked a tipping point historically for great global powers.

Even after the administration backed down from 145% levies on China to a mere 10% or 30% in some cases, Goldman Sachs economists estimate that the U.S. economy faces an increase of some 13 percentage points in the levy on imports, the highest burden since the 1930s during the infamous Smoot-Hawley tariffs. Contrary to the administration's avowed aims, Goldman thinks the tariffs are unlikely to produce much in the way of onshoring of production. That's especially the case for high-value-added products such as medical equipment and semiconductors, which the firm's economists say are less responsive to price changes.

Moreover, Goldman estimates that real -- that is, after inflation -- incomes in the U.S. will be reduced by 1.5%-2% per annum by the tariff regime. But that doesn't take into account potential retaliatory actions by trade partners to the U.S. levies, the firm's economists add. That would only exacerbate the economic impact.

While the tariffs are imposing a consumption tax on U.S. consumers, Strategas Securities' Washington analyst team, led by Daniel Clifton, says the bill's tax cuts at least will provide an offset equal to about 1% of GDP. The timing is inexact; the tariffs will hit consumers with higher prices, as Walmart warned this past week, while the tax relief won't arrive until 2026. It's also far from certain that the BBB won't cost even more. A handful of Republicans from blue -- read high-tax -- states were holding out for a bigger expansion of the state and local tax deduction, otherwise known as SALT.

As Deutsche Bank economists observe, the currently proposed bill may best be thought of as a floor for deficit increases. "In short, there appears to be no serious effort at reining in historically elevated deficits, which remain on track to exceed over 6% of GDP in the coming years," they conclude.

The risks are rising. "Our view is that the nation is headed for a fiscal crisis because the economy cannot sustain budget deficits this big," writes Carl Weinberg, chief economist at High Frequency Economics. "At some point, markets will rebel against unsound fiscal practices, and that includes the wisdom of cutting taxes and increasing the fiscal deficit when the economy is at full employment already, especially if it boosts the public sector debt to more than 100% of GDP," he concludes.

Investors will see a short-term impact as well, according to Mizuho economists Steven Ricchiuto and Alex Pelle. "The prospects of a large tax cut add to our view that interest rates at both ends of the yield curve will end the year decidedly higher than they are today," they say.

The bond market's disquiet already is showing in yields reaching 4.5% for the 10-year Treasury and nearly 5% for the long bond. For the latter, the 5% mark was briefly breached in October 2023 before the Treasury backed away from plans to boost longer-term borrowing but hasn't been seen on a sustained basis since before the financial crisis.

It was a case of the proverbial dog that didn't bark when bond prices failed to benefit from a benign report on April consumer prices this past week, although yields did dip on Thursday following lower-than-expected readings for producer prices and retail sales last month. The so-called term premium -- the extra yield demanded by investors to compensate for the risk of holding longer maturities -- has increased, according to BCA Research, owing to the large fiscal deficits and the pullback by overseas investors owing to concern over Treasuries' safe-harbor status during the first four months of the Trump administration.

Whatever the reason, the upward trend in long-term Treasury yields is apparent to the disinterested markets. Looking just at the charts, Renaissance Macro Research head Jeffrey deGraaf writes that if the long bond yield "were a stock, we'd tell you to 'buy it.' "

Stocks may have celebrated the deal, but higher yields could end the equity party. The 22V Research team led by Dennis DeBusschere says a further rise in longer-term Treasury yields would pose a "headwind" for risk assets, with 4.7% on the 10-year as a level seen by investors as "obviously problematic for the economy."

Raymond James analysts Tavis C. McCourt and David Vargas write that the 4.5% on the benchmark 10-year Treasury has been an important marker for the stock market since 2021. Breaking down the yield impact further, they find returns have "started to noticeably weaken in small-caps once yields are greater than 4.3%, mid-caps once yields are greater than 4.4%, and large-caps once yields are greater than 4.5%."

Above 4.7%, they add, "has been death for equities with almost nothing working across any index as the equity market starts pricing in recession."

The worst-performing sectors when yields rise since 2021 have been communications services, consumer discretionary, and financial services owing to recession fears, and real estate due to leverage concerns. The most resilient sectors since then when yields rise have been utilities, materials, industrials, and energy, they add.

That's a relatively short history. But the experience of most financial market participants has been limited mainly to the post-financial-crisis period of the lowest interest rates in recorded history, including the never-to-be-repeated nadir of 0.56% 10-year yield during the Covid crisis of 2020. But as we noted earlier this year, a 4.75% 10-year Treasury yield is the average for the U.S. since the dawn of the Republic in 1790, according to Bank of America's calculations. Today's supposedly high yields merely represent a return to normalcy.

But an annual budget deficit over 6% of GDP as far as the eye can see -- and a publicly held debt bigger than the U.S. economy -- is anything but normal. The vaunted Department of Government Efficiency cuts, initially promising to save $1 trillion to $2 trillion, have come up with a fraction of that. Meanwhile, the Congressional Budget Office's deficit projections -- which are based on the expiration of the TCJA at year end under current law and none of the added BBB goodies -- assume that the 10-year yield will fall to 3.9% by the fourth quarter of 2026 and then remain around there.

That's liable to be wishful thinking. Simple supply and demand suggest that Uncle Sam will have to pay more to borrow to cover the current deficit and to roll over older, low-rate debt. Financial repression is the expedient means to deal with the deficit. That essentially means holding down interest rates below the nominal growth of the economy, consisting of real GDP plus inflation. To President Donald Trump, the self-proclaimed King of Debt, the BBB doesn't pose a problem.

But for investors in both bonds and stocks, the debt will weigh on future returns.

Write to Randall W. Forsyth at randall.forsyth@barrons.com

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May 16, 2025 14:42 ET (18:42 GMT)

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