Despite falling interest rates and rising tariffs, US bond yields, a weakening dollar, and soaring gold signal foreign investors’ unease with Trump’s budget, risking inflation and financial instability.
As Congress attempts to get President Trump’s One Big Beautiful Bill Act to his desk by July 4, markets are signaling increasing unease about the way that legislation would worsen the country’s public finances. Mr. Trump would be well advised to heed the market’s warnings if he wishes to avoid precipitating a bond market and a dollar market crisis in the run-up to next year’s mid-term elections.
How Will the Big Beautiful Bill Affect the US Economy?
Start with the troubling behavior of the bond market.
Typically, when the Federal Reserve cuts interest rates by 100 basis points, as it has done since September 2022, one would expect long-term interest rates to decline, given the expectation that lower inflation lies ahead.
Yet, that is not what is happening. Instead of declining as might have been expected, the all-important 10-year Treasury bond yield has risen by approximately 60 basis points since September 2024 to its current level of 4.4 percent. This is all too likely signaling that investors, in general, and foreign investors in particular, are beginning to question whether the United States will be able to service its debt obligations without resorting to inflation.
As if to underline this point, in May, Moody’s joined the other major credit rating agencies in stripping the US government of its coveted AAA rating.
The Dollar’s Value Is Already Dropping
The dollar’s 10 percent decline since the start of this year is another warning sign bout the dangers of budget profligacy. Usually, one would have expected the dollar to rise in value on the back of Trump’s import tariff hikes to levels not seen in the past 100 years. Those tariffs have made US goods more competitive than foreign goods, which is a plus for the dollar.
One would also have expected the dollar to appreciate as the difference between US and foreign short-term interest rates rose in favor of the United States, as the European Central Bank and the Chinese central bank have cut their interest rates. In principle, such a widening in the interest rate spread would increase the relative attractiveness of holding dollars.
The fact that the dollar has been sinking like a stone despite these advantages is another warning sign from the markets that foreigners are losing confidence in US economic exceptionalism.
The same might be said of the 30 percent spike in the gold price since the start of the year, as well as indications that several major central banks are shifting their international reserve holdings away from the dollar and toward gold. Once again, this is a sign that investors are beginning to fear that the US will resort to an inflation tax to deal with its debt problem.
Will the United States Have a Recession Soon?
In these circumstances, with markets already flashing warning signs that we might be on our way to a government bond and dollar market crisis, the responsible thing for the Trump Administration to do would be to put our public finances on a more sustainable path. It might do so through both public spending cuts and tax revenue enhancement measures, along the lines of the 2010 bipartisan Bowles-Simpson Plan.
Unfortunately, Mr. Trump’s One Big Beautiful Bill Act would do exactly the opposite by extending the 2017 Tax Cuts and Jobs Act and by eliminating income taxes on tips, overtime pay, and Social Security benefits.
According to the bipartisan Congressional Budget Office, if enacted, it would add approximately $3 trillion to the budget deficit over the next decade. In turn, by 2030, the public debt level would be approximately 100 percent of GDP, a level significantly higher than that prevailing at the end of World War II. It would also result in government spending on interest payments exceeding that on defense.
As if all of this were not sufficient reason for concern, Mr. Trump raises the specter of a return to inflation by continually insisting on Federal Reserve Chair Jerome Powell to aggressively cut interest rates even at a time when inflation remains above the Fed’s 2 percent inflation target.
Trump also further undermines foreign investor confidence by including a clause in his budget bill that would allow him to tax Treasury interest payments to foreigners by up to 20 percent in countries that he deems are following unfair tax policies that harm US interests.
Rudi Dornbusch, the late MIT economist, famously said that economic crises take a lot longer to occur than one would have thought possible. However, when they do occur, they happen much more quickly than one might have thought possible.
Trump would be well advised to pay attention to Dornbusch’s dictum as well as to the market signals that something is already afoot in the Treasury bond and dollar markets. Maybe then he would make a much-needed budget policy U-turn.
However, I would not suggest holding your breath for that to happen.
About the Author: Desmond Lachman
Desmond Lachman is the American Enterprise Institute’s senior fellow and a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging-market economic strategist at Salomon Smith Barney.
Image Credit: Shutterstock/Joshua Sukoff.
