Tariffs vs. the Bond Market — Bonds Always Win
“When I die, I want to come back as the bond market. You can intimidate everybody.”
— James Carville, c.1995
Summary
President Trump’s sweeping tariff announcements have been met with a flurry of adjustments, deferrals, and exceptions – particularly concerning China. While the market has reacted with volatility across equities, commodities, and currencies, the most powerful constraint on this erratic trade policy may not be political or diplomatic, but financial: the U.S. Treasury market.
With nearly $11 trillion in debt to refinance and fund in the coming year, rising yields can quickly erode fiscal space. And as this note explores, international trade flows are directly linked to Treasury demand, especially through the lens of China’s foreign exchange policy. If trade weakens, so too does foreign demand for Treasuries. The market has already begun to flash warning signs.
Tariff Policy Yips
On April 2, 2025 – coined “Liberation Day” by the administration – President Trump unveiled a sweeping schedule of tariffs covering nearly every U.S. trading partner. Rates ranged from a baseline 10% to as high as 104% on Chinese goods. A few days later, the White House announced a 90-day delay for most countries, except China, which would face a punitive 145% tariff. Canadian and Mexican exports not compliant with USMCA provisions were also set to face 25% duties.
Days later, yet another announcement rolled back tariffs on some China-manufactured goods (mostly electronics). Over the weekend, multiple administration officials issued contradictory statements on timing and scope.
The result is what markets loathe most: policy confusion. Whether equities, bonds, commodities, or currencies, risk aversion has spiked across asset classes.
The Indebted Treasury Needs a Calm Bond Market
The U.S. government carries roughly $36 trillion in debt, including around $7 trillion in intra-governmental obligations – money owed to federal trust funds like Social Security and Medicare. While some analysts discount these internal liabilities, we argue they are functionally equivalent to public debt and must be honored as they back-stop obligations of the agencies. This makes the US one of the most indebted OECD nations.
Approximately $9 trillion of this debt matures in the next 12 months and will need to be rolled over. On top of that, the government faces a $2 trillion fiscal deficit, also requiring financing via new issuance.
This refinancing challenge comes at a time when market yields have risen dramatically. The average cost of existing debt is around 3.3%, resulting in ~$1.2 trillion in annual interest payments. However, current Treasury yields range from 3.8% to 4.8% depending on maturity. Based on the current structure of outstanding debt, we estimate a blended refinancing cost of 4.2%, which implies:
- $81 billion in added interest costs from rolling over maturing debt
- $84 billion in additional interest from funding the deficit
Together, this amounts to a 0.5% of GDP increase in interest expense – before accounting for any further rise in yields. This fiscal strain could escalate quickly if markets interpret the tariff policy as inflationary. Not great for a country running a 5.5% fiscal debt-to-GDP ratio.
The Overlooked Link: Trade Flows and Treasury Demand
There’s a critical and often underappreciated mechanical link between international trade and Treasury demand, especially in the case of China (the second largest holder of Treasury debt).
China operates a managed float or “crawling peg” foreign exchange regime. When it exports goods to the U.S., it receives U.S. dollars. To prevent these inflows from flooding its domestic economy, the People's Bank of China (PBoC) intervenes by purchasing the dollars and converting them into renminbi. These dollars are then cycled into foreign reserves, which are typically invested in:
- U.S. Treasuries
- Other reserve currencies (e.g., euro, yen)
- Gold
In effect, China lends the U.S. back the dollars it earns from trade. This loop—import goods, receive dollars, buy Treasuries—has helped keep U.S. yields low for decades.
This isn’t just about China. Many trade-surplus countries use similar tools. Canada and Brazil, for instance, accumulate reserves directly. Norway and Saudi Arabia recycle trade surpluses through sovereign wealth funds. Whether via central banks or investment vehicles, the goal is the same: sterilize trade inflows to manage currency appreciation, while parking reserves in liquid assets like U.S. Treasuries.
Trade Cuts = Treasury Demand Cuts
Here’s the uncomfortable truth: if the U.S. reduces its trade deficit—particularly with countries that hold significant reserves—it also reduces the natural foreign demand for Treasuries.
So far, the U.S. has been able to have it both ways. It buys low-cost goods from abroad (particularly China), then receives that same capital back via Treasury purchases. Tariffs threaten to break this feedback loop. If the U.S. cuts imports, China will have fewer dollars to recycle. Less recycling means less Treasury buying, and that, in turn, forces the U.S. to offer higher yields to attract buyers.
In short, trade and Treasury financing are not independent variables—they are tightly coupled. If the administration pushes hard on protectionism, it should fully expect bond yields to rise. And as we’re already seeing, the bond market has no patience for experiments that raise its cost of lending.
Conclusion: Watch the Market That Can Say No
Tariff policy may be driven by ideology or political strategy, but the bond market doesn’t care. It responds mechanically and immediately to changes in supply, inflation expectations, and credibility. So far, it has made clear what it thinks of the current course.
Policymakers may be able to dial up rhetoric or walk back individual announcements, but unless the U.S. Treasury regains yield stability, any trade war risks becoming a fiscal one.
The bond market always wins.
