US budget and trade deficits: Catalysts for yield curve steepening and a credit downgrade

The US economy is facing mounting pressure from widening trade and budget deficits, both of which are contributing to a steepening yield curve and weakening credit conditions. Recent data highlights the impact of tariffs, fiscal policy, and global trade dynamics on the country’s economic outlook. Read our insight to discover:

• Trade deficit surge: Pre-tariff imports rose by 41.3% in early 2025, pushing the trade deficit to $163 billion in March, driven by consumer goods and capital equipment.
• Credit profile under strain: Moody’s downgraded the US credit rating due to rising debt and fiscal deficits, with the 5-year CDS widening by 20 basis points.
• Yield curve steepening: Long-term yields are climbing amid fiscal concerns and trade tensions, with the 30-year Treasury yield reaching a 19-month high.

The US reported a 0.3% quarter-on-quarter contraction in GDP for Q1 2025. The decline was driven by an increase in imports - which are subtracted in GDP calculation - and a decrease in government spending. These effects were partly offset by increases in consumer spending and exports. The odds of a recession have been on the rise since the Trump administration started implementing tariffs. Even though the tariffs had not been fully implemented during the first quarter of the year, they still triggered significant imports as businesses tried to front-load purchases ahead of their implementation. 

Data shows that pre-tariff imports rose by 41.3% in the first three months of the year. Imports reached $346 billion in March, widening the trade deficit to $163 billion. Consumer goods led the surge, with notable increases in imports of automotive vehicles and capital goods.

Consumer confidence fell by 9% in April, compared to the previous month. However layoffs remained low, and employers added more jobs than expected. The unemployment rate remained unchanged at 4.2%. The US job market resilience has surprised many analysts, with past forecasts projecting an increase in the unemployment rate. This was particularly true during the tightening phase of monetary policy led by the Fed. However, even though the US job market currently manages to exceed expectations, the implementation of tariffs is expected to worsen the job market conditions. Time series data indicates consumer confidence is a relevant early warning sign of stress in the job market. The GDP contraction for Q1 2025 is another sign of stress.

During Trump's first term, the overall trade deficit increased following the implementation of tariffs, despite a partial reduction in the deficit with China. Asian countries that benefitted from the shift in the supply chain included Vietnam and Thailand, with both countries’ trade surplus with the US increasing. Tariffs can change the US trading partners relative contribution to the trade deficit, but they do not reduce the trade deficit. The deficit in the US reflects the imbalance between savings and investments, as domestic investments far exceed savings. This imbalance implies borrowing from abroad in order to fund the deficit, which in turn leads to capital inflows.

Asian countries running a large trade surplus with the US typically hold a significant number of US Treasuries. As the world’s reserve currency, foreign investors typically invest more into US assets than Americans invest abroad. These net capital inflows fuel the demand for the US currency which drives the value of the currency upward making imports cheaper and exports more costly.

Not only did the trade deficit widen recently in the US, but the budget deficit is also raising concerns over its sustainability and its trajectory. Namely, Moody’s decided to downgrade the US long-term issuer and senior unsecured ratings to Aa1 from Aaa. The rationale behind the downgrade is that the US federal debt has been rising due to continuous fiscal deficits. As deficits and debt have grown, and interest rates have risen, interest payments on government debt have increased markedly. 

Considering the cost of servicing the government debt and the US fiscal trajectory, the downgrade is consistent with other rating agencies’ opinions. After the announcement, the cost of insuring against a US default increased substantially, chiefly, the US five-year credit default swap widened by 20 basis points. The US 5-year CDS now trades well above countries with similar ratings such as Austria and Finland, which reflects the deterioration of the US credit profile.

The 30-year US treasury yield reached its highest level in 19 months in May, amid concerns over the US fiscal outlook. After the credit downgrade announced by Moody’s, the US House of Representatives passed Trump's tax bill, which will further add to adding to the country's debt. The enacted legislation extends some $4.5 trillion in tax breaks introduced during Trump’s first term in 2017. The Committee for a Responsible Federal Budget estimated the cost of the bill to be $3.1 trillion over the next decade, which is about 11% of the current US GDP. As a result, the Congressional Budget Office now projects a budget deficit near 7% of GDP in the coming years. 

The Fed is expected to loosen its monetary policy later this year, while volatility is weighing on the longer end of the yield curve, driving it upwards. We expect the yield curve to steepen further, the evolution of this process will depend on the developments around the trade war and the odds of recession. The effective tariff rate should stabilise slightly above 10% in the coming months, however, the road towards terminal tariff rates may be challenging and depend on the progress in ongoing trade talks. 

In summary, the volatility implied by the shifting trade landscape impacts both the trade and budget deficits, with the trade deficit expected to widen further. The revenues generated by taxing imported goods to the US will not make up for the 2025 tax cuts, which in turn, will contribute to the widening of the budget deficit. The US fiscal trajectory will affect the credit profile of the country, and the cost of borrowing as well.  

At the current pace, estimates indicate that the debt-to-GDP ratio should increase by about 8% to 10% within the four-year term. Bond sensitivity to the debt-to-GDP ratio has been examined, and it has shown that a 10% increase in debt-to-GDP should lead to a 99 basis points bump upwards for long dated bonds. Arguably, the long end of the US yield curve could reach a new high by the end of President Trump’s term. Indeed, after breaching the 5% threshold in 2025, it could potentially breach the 6% threshold in the coming years.