Finally, a week where the news agenda hasn’t been about tariffs… but there’s been plenty going on to fill the void
The UK and EU began the process of resetting the post Brexit relationship, while across the pond the battle has begun over agreeing a new Federal Budget. With the US deficit already at alarming levels, we’ve seen a few jitters in US government bonds this week given the new budget appears unlikely to address America’s ballooning debt levels.
Monday saw the UK and EU announce a deal to ‘reset’ post Brexit relations. For now, a defence and security pact forms the backbone of the deal, allowing UK firms to participate in a European arms procurement fund as part of a wider recognition that the defence of ‘Europe’ stretches beyond the boundaries of the European Union. The deal also removes a limited number of some of the worst Brexit related trade frictions, but the key point is this represents the initial phase of further negotiations to remove more barriers. The deal will see alignment on most food standards, along with an extension of already agreed fishing rights for a further 12 years. Removing barriers to trade in food will require the UK to accept ‘dynamic alignment’ with EU regulations, which means accepting the jurisdiction of the European Court of Justice. Revisiting the definitions of the 2016-2020 period, this is still very much a ‘hard Brexit’ – the government is not making any attempt to rejoin the single market or customs union or shifting ‘red lines’ on the free movement of people. PM Keir Starmer called the agreement as a ’common sense, practical solution’ that moved on from the ’stale old debates’ about Brexit. EU Commission President Ursula von der Leyen described it as a ’new chapter’ in the EU-UK relationship. The deal overall is relatively small in terms of economic contribution to the UK (a contribution of around 0.5% of GDP over 15 years) but it remains a step forwards in that it paves the way for discussions to eliminate further barriers over time, with talks ongoing and a commitment from both sides to an annual ‘summit’. The UK government has developed some momentum recently on trade, with ‘deals’ with the US, India and the EU. This last deal is by far the most important, given 46% of UK trade takes place with the economic bloc.
In the economic news, the latest UK inflation data surprised to the upside, with CPI in April at 15 month high of 3.5% year on year, higher than expected and a significant increase on March’s figure of 2.6%. Inflation was pushed higher by a number of regulated bills, including water, rail fares and the energy price cap, which increased by 6.4%. CPI for the services sector, closely watched by the Bank of England (BoE), climbed to 5.4% from 4.7% previously. As a result of the data, expectations for rate cuts from the BoE dipped with markets only fully pricing one rate cut in 2025, and not before November. BoE Chief Economist Huw Pill said [before the CPI data was released] that the recent pace of UK rate cuts is ‘too rapid given the balance of risks to price stability we face’. Pill was explaining his vote at the last BoE meeting where he voted against the decision to cut rates by 25bps and said he felt the momentum behind falling inflation was ’stuttering’. Further afield, the monthly ‘data dump’ from China was mixed, with retail sales showing a notable slowdown, albeit still rising by +5.1% year on year, but slowing from +5.9% previously and below expectations. Yesterday saw the flash PMI data published, which showed continued resilience in the US economy but a softer outlook for the UK and eurozone.
In the US, the new federal budget has been making the headlines, as Republicans try to agree on a budget deal that will pass through Congress without Democrat support. President Trump has attempted to package many of his election promises on tax into what is now officially called ‘The One Big Beautiful Bill Act’ which is now making its way through Congress. The debate about the budget this week has taken place against a backdrop of a warning shot fired by the Moody’s rating agency as it downgraded the US from a AAA rating. This means none of the major ratings agencies now give the US the highest credit rating. S&P downgraded the US as far back as 2011, citing deficit concerns. Very little has changed, with the US currently running a budget deficit of 6.8%, a level only usually seen in a recession. Moody’s was the last of the rating agencies to have rated the US with the highest credit rating of AAA and cut the rating by one notch with a “stable” outlook. Moody’s said it expected the federal deficit to widen to 9% of GDP by 2035, from 6.4% in 2024 owing to increased payments of debt, entitlement spending and “relatively low revenue generation”. Treasury Secretary Scott Bessent has previously promised to cut the deficit to 3% by the end of Trump’s presidential term. The Moody’s downgrade has little practical impact but dampens sentiment and is very timely given the focus on the US budget, its implications for future borrowing and the apparent lack of concern in Washington over the direction of the deficit. Treasury Secretary Bessent said Moody’s was a “lagging indicator” and blamed the Biden administration for “the spending we have seen over the past four years… we are determined to bring the spending down and grow the economy”.
President Trump visited Congress to put pressure on House Republicans to strike a deal on his ‘big, beautiful’ bill which extends tax cuts delivered in 2017 that are due to expire at the end of the year. The bill narrowly passed in the House following an all-night session on Wednesday and passed up to the Senate, where it is likely to be amended to address concerns that in its current form it does little to address the ballooning deficit with some Republicans calling for more cuts and changes to state and local taxes. The non-partisan Committee for a Responsible Federal Budget estimates the bill will increase the US national debt by at least $3.3 trillion over the next decade. Meanwhile the IMF’s managing director Gita Gopinath called on the US to reduce the deficit and tackle its “ever increasing” debt burden, noting the US was still being impacted by “very elevated” policy uncertainty despite “positive developments” with the paring back of tariffs on China.
The market reaction to the US downgrade saw some volatility in US Treasuries, most notably in longer duration debt. Markets are expecting a resolution to the budget, with a deal set to pass Congress in the not-too-distant future. However, it seems likely this bill will do little or nothing to address the debt issues. The limited spending cuts in the bill will fail to offset the tax cuts proposed, or the extension of tax cuts introduced in 2017. Revenue from tariffs are unlikely to plug the gap. Last year the US took $100 billion in tariffs compared to overall receipts of $4.9 trillion. This year, the expected number may well be in the $150-300 billion range – but the upper bound of that range would infer that reciprocal tariffs are reimposed, which appears unlikely. This leaves the US with a deficit likely to grow swiftly from the current $ 36.2 trillion, with interest payments on this debt likely to be close to $1 trillion this year, up three-fold since 2020.
With the US deficit recently growing at a pace of $1 trillion every 100 days, what will bring a halt to the ever-growing US debt burden? It seems unlikely fiscal restraint will come from the Republican party or the current administration, so will the bond market finally scream “enough” and give Donald Trump a ‘Liz Truss moment’? US Treasuries still have the luxury of being seen as the ultimate risk-free asset (if you assume the US government won’t default), while the US dollar remains the world’s reserve currency. This should mean that there is always a substantial level of demand for US debt. But it seems likely investors will want higher rewards for owning that debt. US government bonds will be priced against a backdrop of the risk of higher inflation risks and a slowing economy thanks to tariffs, with the Federal Reserve in ‘wait and see mode’, more concerned over the inflation side of their mandate rather than employment. We’ve seen in the past that the US Federal Reserve is acutely aware of any stresses in bond markets, and will intervene if necessary, so that a bond crisis does not become a financial crisis. But the bar for intervention is high, and beneath that we may well see some volatility. Yields rising slowly over time are much easier to digest than a sudden spike, but the news backdrop around the deficit lends itself to swift changes in the market mood and the kind of spikes in yields that cause fallout across risk assets. There are definitely reasons to feel a little more nervous about the trajectory of US debt and how this will influence risk appetite across all financial markets.
Source: Columbia Threadneedle Investments as at 23 May 2025.
