US fiscal policy, the bond market, and gold.

Rising concerns around US fiscal solvency and sustainability and potential for financial repression are widening the US Sovereign CDS spread, weighing on the US dollar and supporting gold.

Policy uncertainty has exploded under President Trump…

Since the inauguration of President Trump on the 20^th of January, we’ve seen a surge in policy uncertainty with The Policy Uncertainty Project’s estimate of daily policy uncertainty index climbing to levels not seen in its forty-year history. The rise in economic policy uncertainty spans multiple aspects of policymaking including the US geo-political position, trade, immigration, regulatory, and fiscal policy, and it may soon also include policy surrounding the US Federal Reserve.

Historically, episodes of sustained policy uncertainty have gone together with a rise in the personal savings rate – as households increase their precautionary savings – weakness in investment and employment activity by firms, wider corporate credit spreads, weaker equity prices and strength in the price of gold. The longer policy remains uncertain and the greater that uncertainty, the more likely it will be associated with these adverse economic consequences (although positive for gold).

…with focus shifting from trade to the budget.

On the 16^th of May, Moody’s Ratings cut the US Sovereign credit rating one notch, to Aa1 (from Aaa), bringing its rating into line with S&P Global and Fitch Ratings. In downgrading US Sovereign debt, Moody’s noted “if the 2017 Tax Cuts and Jobs Act is extended, which is our base case, it will add around $4 trillion to the federal primary (excluding interest payments) deficit over the next decade.” If this occurs, sustained large scale fiscal deficits are expected to see the federal debt burden “rise to around 134% of GDP by 2035, compared to about 98% in 2024”. The effect of this will be to balloon debt servicing costs from around 9% of federal revenue in 2021 to around 30% by 2035.

The US budget bill narrowly passed a vote in the House of Representatives by a 215-214 margin, sending it to the US Senate, with the budget now in reconciliation. Whether the budget survives in the Senate remains to be seen given the Republican’s 53-47 Senate majority. Already, Sen. Rand Paul (R-Ky) has said he won’t vote for the bill, arguing for deeper cuts to spending while Sen. Ron Johnson (R-Wis) has expressed his concern about the scale of additional fiscal borrowing and a group of Republican senators have expressed concerns about termination of energy tax credits and cuts to Medicaid.

The Penn-Wharton budget model (HERE) indicates that even with significant cuts to spending on agriculture, education and welfare, energy and commerce, the primary budget deficit will increase by USD 557bn (1.8% of GDP) in FY2026 with the cumulative impact through to FY2034 being an increase in the primary budget deficit relative to baseline of USD 4,806bn, adding 11.3% of GDP to the fiscal debt-to-GDP ratio. The primary driver of the expansion in the fiscal deficit is the decision to extend the 2017 Tax Cut and Jobs Act individual and estate tax provisions, adding USD 346bn to the fiscal deficit in FY2026 and USD 3,671bn over the budget period through 2034. Restoring TCJA business and international tax provisions and individual and estate tax provisions would add a further USD 194bn to the fiscal deficit in FY2026 and USD 1,844bn to the deficit through 2034.

Proposals to reduce Medicaid – largely through tighter work requirements, increased eligibility testing, reduced Federal assistance for undocumented migrants, cost-sharing and capped payments – is budgeted to save USD 900bn. The Department of Agriculture’s overall spending is budgeted to fall by USD 230bn over the budget period, but farm subsidies are slated to increase by USD 60bn while the Supplemental Nutrition Assistance Program (SNAP) is budgeted to be cut by USD 290bn largely through tighter eligibility requirements and pushing costs to the States. The Education and Workforce Committee’s proposals include a reduction in spending by USD 350bn, largely falling on student loans.

The Penn-Wharton Budget Model shows that changes to taxation and spending plans contained in this budget would be highly regressive, with costs falling on younger and lower income cohorts to the benefit of older and higher income cohorts, although the worst off are the older poor. These distributional issues are likely to be magnified given the impact of US tariff policy.

It remains to be seen whether this budget or something similar is ultimately adopted. What is clear however is that absent significant revenue generation from tariffs, it’s hard to see the fiscal deficit not rising rapidly from already problematic levels.

Of tariffs and the budget.

While President Trump has couched his tariff policy in terms of fairness/reciprocity and a desire to bring manufacturing and related jobs back to the United States, the primary motivation for tariffs is likely to have been fiscal. Simply put, President Trump needs tariff revenue to help offset his taxation and spending plans while mitigating the potential impact on the primary budget deficit and debt-to-GDP ratio.

My back-of-the-envelope calculations suggest the average effective US tariff rate is currently around 14%, but if President Trump were to enact a 50% tariff on imports the Yale Budget Lab (HERE) estimates the average effective tariff rate would climb to 21.9%. After adjusting for likely changes to consumer behavior resulting from the tariffs, the US effective tariff rate would still be 20.7%, its highest level since 1910. The Yale Budget Lab estimates that if the tariffs announced as of 23^rd of May were to be enacted, they “would raise USD 2.8 trillion over 2026-35” (USD 280bn p.a. average) but dynamic effects on taxation would reduce tax revenue by USD 549bn over this period, yielding as a rough rule of thumb an increase in tax revenue in the region of USD 225bn p.a.

That’s helpful from a budget perspective, but it would still leave the primary fiscal deficit hovering around 3% per annum, implying a still explosive accumulation of debt.

Ignoring the IMF…

In their 2024 Article IV consultation, the IMF’s Directors noted “the pressing need for a frontloaded fiscal adjustment, through both revenue and spending measures, while redirecting some of the fiscal savings to programs to alleviate poverty.” With the Article IV noting that “to put debt-GDP on a clear downward trajectory, a frontloaded fiscal adjustment will be needed that shifts the general government to a primary surplus of around 1 percent of GDP (an adjustment of around 4 percent of GDP relative to the current baseline).”

It would seem President Trump’s policies invert this.

Pressure on the bond market…

Since the 1^st of April we’ve seen a significant increase in the US ten-year bond yield, to 4.43% (+28bp) with TIPS indicating the rise has been driven entirely by the real yield, which has now increased to 2.10%. While the rise in bond yields since prior to President Trump’s ‘Liberation Day’ announcement is significant, it’s important to keep in mind that the ten-year bond yields (real and nominal) are only back to more-or-less where they were at the start of the year.

The rise in US nominal and real long-term bond yields appears to have been driven by a lift in short-term rates, the one-year swap yield is up 15bp, and a rise in the US Sovereign credit default spread, up 12bp. So, it appears the lift in bond yields since pre-Liberation Day can be accounted for by an expectation of tighter US monetary conditions and a lift in the Sovereign risk premium. With fiscal policy under pressure, financial market participants are likely to pay increasing attention to announcements surrounding the US bond issuance program and auction tenders.

As the US mortgage market is priced off the 30-year rate and equities are responsive to changes in the long-term bond yield, a rise in long-term interest rates has the potential to tighten financial conditions. To the extent that this is viewed as unwelcome by the US Federal Reserve, it increases the likelihood of reductions in the Federal funds rate, weighing on the US dollar and supporting gold.

Normally, I’d view a rise in US long-term real bond yields as generally negative for gold and precious metals. But, if it’s driven by an increase in the US Sovereign risk premium, it’s likely to be associated with increased risk aversion and safe-haven demand, supporting gold, so the effect of changes in real interest rates on gold is ambiguous, depending on what’s driving the adjustment.

Concerningly, the widening in US Sovereign CDS is occurring at a time of generally tight credit spreads, with the deviation between the US five-year Sovereign CDS spread and that of Indonesia falling to just 17bp.

Risk of a ‘Sudden Stop’ and/or financial repression is increasing.

While President Trump wishes to see the US merchandise trade and current account deficits contract, there is a natural tension between his fiscal and trade policies.

While the US current account balance can be expressed in terms of flows through the balance of payments, it is also equivalent to the difference between domestic savings and investments (CA = X-M = S-I). When looking at the savings-investment balance we can break the savings balances down by type; household, business (or private) and government. To the extent that we see a wider savings-investment imbalance driven by wider government budget deficits, we’re likely to see either a higher current account deficit and/or narrower private sector savings-investment imbalance. Simply put, expansionary fiscal policy will either push the current account deficit wider – leading to more rapid accumulation of foreign liabilities – or it will have to crowd out net domestic savings. A key mechanism for the latter being higher interest rates, which will weigh on asset returns.

As businesses and households attempted to pre-empt the impact of tariffs, I expect the US to post a significant expansion in its current account deficit this year, with the deficit totaling around USD 1,300 bn (4.3% of GDP), with the deficit set to contract to around USD 1,000bn (3.2% of GDP) next year as the effects of higher imported prices and slower economic growth weigh on imports. This still leaves the US reliant on foreign capital to balance its payments. While much is made of equity-linked capital flows, the reality is that the bulk of the US current account deficit is funded by debt-linked flows, notably purchases of US Treasury bonds, Agency bonds, and short-term T-bills and money market instruments.

To the extent that foreigners are unwilling to purchase US debt securities, we’re likely to see upward pressure on bond yields, and downward pressure on the US dollar with a rise in the US debt risk premium and a weaker US dollar likely to be associated with a stronger price of gold.

While this ‘flow-pressure’ is significant, the US is also vulnerable owing to its sizeable gross external liabilities, leading to the potential for a ‘stock adjustment’, which may come in the form of foreigners selling USD-denominated assets, or hedging their currency exposure.

As of the end of 2024, US gross international liabilities amounted to USD 62,118bn (209% of GDP) with USD 25,837bn (87% of GDP) comprising debt-creating liabilities (e.g. T-bills, T-bonds, Agency bonds, money market instruments, loans, and financial derivatives). Even a tiny adjustment in foreign portfolio holdings/hedging has the potential to create significant flow-effects in the foreign exchange market. For instance, if foreigners were to hedge just 1% of this holding, it would amount to USD 258.4bn in selling of US dollars. Even within the context of the US dollar market, this is significant.

Anecdotally, it appears foreigners have been liquidating US dollar assets and/or increasing their hedging ratio, and this explains the recent divergent performance between US long-term bond yields (higher) and the US dollar (lower).

Conclusion

The deteriorating US fiscal balance is a cause for concern, and not just in the long-term but here and now. The Trump Administration needs tariff revenue to help plug the gap in the fiscal accounts created by President Trump’s plans surrounding extension of the TCJA and other taxation policies, with expenditure cuts unlikely to materially correct the deficit (I expect the Senate to walk back some of the House’s more aggressive spending reduction measures). Upward pressure on bond yields appears to have been driven by a confluence of higher expected short-term rates – driven in part by tariffs – and a higher sovereign risk premium, hence it’s had little impact on gold.

A reduction in the willingness of foreigners to fund the US Twin Deficits suggests upward pressure on bond yields and downward pressure on the US dollar, tightening financial conditions and placing pressure on the Federal Reserve to run an easier policy stance. As the fiscal straight jacket tightens, foreigners are likely to become more concerned about the stock of their assets held in the US, increasing risk of a disorderly adjustment and the possibility the US resorts to financial repression.

All these factors suggest investors are likely to continue to adjust their investment portfolio in the direction of gold and other long-term stores of value.

The information in this publication is provided by Redward Associates Private FZCO for informational purposes only. The insights contained in this publication are not investment advice and should not be construed as such, nor as a recommendation for any specific investment product. Our full disclaimer can be found HERE.