Gradually, Then Suddenly

Three months ago, stock-market investors were in full-fledged panic mode after President Trump unveiled a sweeping new tariff regime. Bond investors also revolted, pushing the 10-year Treasury yield up by half a percentage point within days. Markets feared that a global trade war would stifle U.S. economic growth and fuel inflation.

Confronted by mounting financial market turmoil, the administration quickly backtracked, temporarily delaying many of the proposed tariffs. Fast forward to Independence Day and the major stock market indexes had recovered all of their losses, with the S&P 500 and Nasdaq Composite achieving new record highs.

No deal

This sharp market reversal seems at odds with the still-unsettled trade situation. Back in April, White House trade advisor Peter Navarro boldly predicted “90 deals in 90 days”, expecting U.S. trading partners to eagerly offer concessions to avoid massive import taxes. But the 90-day window came and went with only two agreements to show for it—one with the United Kingdom and another with Vietnam. Trump has also announced the framework for a deal with China, though the details remain fuzzy.

The president has since extended the negotiation deadline to August 1 and tinkered with his threatened tariffs, leaving the global trading system pretty much where it stood three months ago—in a state of limbo. Yet the incessant drama on the trade policy front has been met by an absence of drama in the financial markets. Despite the ongoing uncertainty, investors have grown curiously indifferent to the risks of a trade war.

Going stag

This apparent complacency suggests investors are betting on one of two favorable outcomes: Either significant concessions from major trading partners will soon materialize, or the White House will once again back away from its line in the sand if faced with renewed market backlash. While dozens of trade deals remain theoretically possible, the reality is that such agreements typically take months, if not years, to finalize and implement.

Meanwhile, the unpredictability of trade policy has left businesses in a state of suspended animation, causing firms to delay investment and reevaluate their global supply chains. Surveys show a contraction in new orders and a noticeable pullback in capital spending plans. Uncertainty, after all, is the enemy of business decision-making. CEOs cannot commit to long-term investment when the rules of the game are not clear.

Despite the temporary reprieve, the average effective tariff rate on U.S. imports has climbed to approximately 16%, a dramatic increase from the 2.5% average levy in place prior to Trump 2.0. Tariff hikes are classic stagflationary shocks: They simultaneously slow growth and push prices higher. As tariffs arrive in force, economic momentum will weaken, unemployment could rise and consumer spending may decline.

Heads I win, tails you lose

As Federal Reserve Chair Jerome Powell has warned, someone must ultimately pay these taxes. If companies pass higher import costs on to consumers, inflation could rise and from a base that is already above the Fed’s comfort zone. That would likely push interest rates higher, pressuring both stock and bond prices. Alternatively, if companies absorb the added costs, profit margins will shrink—also bad news for equities.

So far, the broader economy has been partially insulated from the full impact of tariffs thanks to strategic inventory building early in the year. In addition, many firms have shouldered the initial cost of tariffs. But those buffers are fading. With supply chains strained, manufacturers struggling with steeper input costs, and retailers’ inventories dwindling, higher consumer prices are all but inevitable. Walmart, Target and others have already warned of price hikes. The Yale Budget Lab estimates that if current tariff rates persist, the median household could see a 2% hit to income.

Fiscal follies

While the trade war poses a near-term risk for both the U.S. economy and financial markets, a deeper and more structural challenge looms: the nation’s deteriorating fiscal condition. The U.S. public debt trajectory was already unsustainable long before the passage of the so-called One Big Beautiful Bill (OBBB), which introduced a mix of tax cuts and spending changes. On one hand, the OBBB should boost economic growth over the next few years since the more expansionary measures (tax cuts) are front-end loaded while the restrictive aspects (spending cuts) will be concentrated later in the decade.

However, the longer-term fiscal implications are troubling. Incremental economic growth will not be sufficient to prevent a worsening of the U.S. fiscal position. All major, non-partisan budget authorities agree that this legislation will significantly expand annual deficits over the next 10 years. The U.S. will need to issue ever-larger volumes of debt just as interest costs on existing obligations are ballooning. In short, there is no free lunch here.

Annual budget deficits are projected to hover around 7% of GDP, levels previously seen only during recessions or wartime. Analysts forecast government spending to run $7 trillion annually, while revenues remain closer to $5 trillion. This means federal debt, currently equal to 100% of GDP (roughly $230,000 per household), could rise to 130% ($425,000 per household) over the next decade. Debt service—principal and interest—will jump from $10 trillion to $18 trillion per year. Annual interest payments alone are set to double from $1 trillion to $2 trillion, already exceeding what the U.S. spends on Medicare or national defense.

Gradual truths

Mounting deficits and debt could eventually trigger structurally higher interest rates as bondholders demand greater compensation to absorb the supply and accept the growing credit risk. It may take a rebellion by the bond market—led by so-called bond vigilantes forcing up yields—to prod policymakers into action and alter the trajectory of the debt cycle. Yet history offers little assurance that either party is willing to confront hard fiscal truths. Political leaders have repeatedly chosen to avoid tough choices rather than risk voter backlash.

The potential consequences extend far beyond the budget ledger. Ballooning debt also translates into fewer available resources for public investment in areas such as infrastructure, scientific research, and defense—engines of productivity growth, economic vitality, and national security. Moreover, an overleveraged government will have less flexibility to respond to future recessions, crises, or security threats.

In Ernest Hemingway’s novel, The Sun Also Rises, one of the characters describes his descent into bankruptcy as happening “Two ways. Gradually, then suddenly.” The United States is certainly not on the edge of financial ruin. It still commands the world’s most dynamic economy, deepest capital markets, most trusted currency, unrivaled military, and most innovative private sector. But federal finances have been drifting for decades toward a breaking point. Eventually, the shift from gradual to sudden could arrive—and with little warning.

Reckoning at some point

While uncertainty surrounding the OBBB’s passage has been resolved, the global trade outlook remains deeply unsettled. Rewriting trade rules is a slow, complex affair. And seemingly emboldened by resilient U.S. financial markets, the president continues to float new tariff threats with little warning.

Together, the twin pressures of trade and fiscal dysfunction present an unusually potent cocktail—one that could destabilize the economy and markets over time. And the Federal Reserve, already constrained by elevated inflation, lacks the tools to come to the rescue. Investors may continue to shrug off the risks for now, but the longer these issues fester, the greater the chance that market sentiment turns.

There is little compelling economic or financial rationale for a broad, indiscriminate trade war against both allies and adversaries. And decades-long fiscal inaction will eventually exact a price. The time for structural reform is now. Waiting for a crisis to impose discipline will make the reckoning far more painful.

— Christopher J. Singleton, CFA, Managing Director

July 15, 2025