Why Bond Markets Are Underestimating U.S. Fiscal Risks in a Trump Tariff Era

The U.S. bond market is operating under a dangerous illusion: that the fiscal risks of President Trump’s aggressive tariff regime and expansive fiscal policies are being adequately priced into sovereign yields. Yet Nobel laureate Joseph Stiglitz and a growing chorus of economists warn that markets are underestimating the long-term implications of protectionist policies, which are distorting trade flows, inflating deficits, and accelerating a debt trajectory that could destabilize global capital markets.

The Fiscal Tightrope: Debt, Tariffs, and Lagged Effects

The U.S. national debt is projected to reach 125% of GDP by 2034, driven by extended tax cuts and rising deficits [1]. This trajectory is exacerbated by Trump’s tariffs, which have pushed the effective average tariff rate from 2.5% to 18.6% by August 2025 [2]. While tariffs initially generated revenue—accounting for 5% of federal income in July 2025—they are now backfiring. Businesses are shifting supply chains to avoid tariffs, reducing projected revenue and worsening fiscal pressures [3]. Stiglitz argues that this “tariff financing” is a mirage: “Firms will find ways to minimize exposure, leaving the Treasury short and deficits unaddressed,” he warns [1].

The lagged impact of these policies is critical. Tariffs distort trade imbalances rather than resolve them, as Stiglitz notes, because trade deficits are rooted in macroeconomic imbalances like fiscal policy and exchange rates, not bilateral trade flows [2]. Yet bond markets remain fixated on short-term revenue gains, underpricing the long-term risks of a debt-dependent economy.

Bond Yields and the Illusion of Stability

Despite these risks, U.S. 30-year Treasury yields have surged to 5%, reflecting investor anxiety but not the full scale of fiscal vulnerability [1]. A recent downgrade of U.S. debt by Moody’s has done little to shake complacency, as markets continue to treat Treasuries as a “safe haven” despite their growing exposure to structural deficits. This disconnect is evident in the bond market’s underestimation of currency volatility and the potential for a global currency war. As Stiglitz highlights, retaliatory tariffs and misaligned exchange rates could trigger cascading failures in global supply chains and capital flows [4].

The Federal Reserve’s cautious approach to rate cuts—projecting a neutral rate of 4.5%—further masks the problem. While inflation has eased to 3.6%, the Fed’s reluctance to act aggressively suggests it is underestimating the inflationary drag of protectionist policies [5]. Meanwhile, global investors are shifting toward high-yield corporate and municipal bonds, betting on short-term returns while ignoring the broader fiscal risks [3].

Global Investor Strategies: A Misaligned Prioritization

Investors are recalibrating portfolios in response to trade tensions, but their strategies remain misaligned with the scale of the challenge. The U.S. dollar’s decline to a three-year low has spurred interest in international equities, yet this diversification overlooks the systemic risks posed by U.S. fiscal expansion. For example, the “One Big Beautiful Bill” (OBBB)—a $4.5 trillion fiscal stimulus package—has already strained credit spreads and increased borrowing costs [5].

Stiglitz’s critique of unilateral tariff policies is particularly relevant here. He argues that protectionism creates “a false sense of security,” as markets fail to account for the retaliatory measures and supply chain disruptions that will ultimately erode economic resilience [2]. The Penn Wharton Budget Model’s projection of a 6% long-run GDP loss from tariffs underscores this risk [5].

The Path Forward: A Call for Rebalancing

The solution, Stiglitz and others argue, lies in a coordinated global rebalancing framework—a “G3” agreement to address fiscal, monetary, and trade imbalances [2]. Without such an approach, the U.S. and other economies will remain trapped in a cycle of protectionism and fiscal overreach, with bond markets ill-equipped to price in the full cost of these policies.

For investors, the takeaway is clear: the current underpricing of U.S. fiscal risks is a ticking time bomb. While Treasuries remain a benchmark asset, their yields fail to reflect the growing fragility of a debt-dependent economy. As Stiglitz warns, “The market’s slow adaptation to tariff-driven fiscal shifts is a recipe for crisis.” Investors must act now to hedge against the lagged impacts of protectionism, lest they find themselves on the wrong side of a market correction.

Source:
[1] Budget pressure starts to bite, and other economic news [https://www.weforum.org/stories/2025/06/pressure-on-budgets-starts-to-bite-amid-upheaval-and-other-key-economic-news-to-know/]
[2] Tariffs in the second Trump administration [https://en.wikipedia.org/wiki/Tariffs_in_the_second_Trump_administration]
[3] Nobel Prize winner Joseph Stiglitz warns U.S. markets [https://www.cnbctv18.com/world/nobel-prize-winning-economist-joseph-stiglitz-warns-us-markets-underestimating-fiscal-risks-despite-easing-bond-yields-trump-tariffs-19665597.htm]
[4] Rebalancing the world economy: Right idea but wrong [https://www.brookings.edu/articles/rebalancing-the-world-economy-right-idea-but-wrong-approach/]
[5] United States Economic Forecast Q2 2025 [https://www.deloitte.com/us/en/insights/topics/economy/us-economic-forecast/united-states-outlook-analysis.html]