Concerns regarding fiscal policy have increased, posing a risk of a sharp sell-off in long-dated developed market bonds.
US trade and fiscal policy remain sources of deep uncertainty for the global economy, even though our forecasts of the size of the tariff shock have scaled down. The US-weighted average tariff rate currently stands at 12% (Chart 1), which leads us to condition our baseline forecasts on this rising only slightly from here.
Chart 1. We expect the US average tariff rate to ultimately settle a little higher than its current rate
Legal challenges to President Donald Trump's reciprocal tariffs were always likely. However, the strength of the ruling on the ability to use the International Emergency Economic Powers Act (IEEPA) still came as a surprise.
Whether the administration wins its appeal will in large part come down to a ruling on the “major questions doctrine” – effectively whether the executive branch can impose such sweeping changes without Congress signing off on it – and a judgment will likely be made in the next few months.1
Should US courts uphold the decision, this has the potential to shift the power balance on tariff setting more in favor of Congress, thereby reducing the risk of substantially higher tariffs. But the raft of alternative legislative options (Sections 122, 232, 301, 338) suggests that tariffs will remain an active policy lever of the executive branch.
Bipartisan support for a "Tough on China" approach means that we are assuming tariffs on Chinese imports rise back to 40% or more.
In any case, the softening in trade actions and rhetoric has helped stabilize many markets. The economic consequences are just beginning. Data is likely to be scrambled in the coming months, with US Q1 GDP contracting due to a surge in imports ahead of tariff imposition, but an offsetting boost to inventories and sales is likely to show up as a strong Q2.
However, looking through the noise, uncertainty will weigh on hiring, investment, and durable goods consumption. At the same time, weaker real income growth will also slow the economy over the second half of the year. However, while markets are less concerned about the tariff shock, they are increasingly on edge about fiscal policy in the US and developed markets more generally.
Reconciliation of the One Big Beautiful Bill Act (OBBBA) could be concluded by the Fourth of July, or soon after, and we expect this to push the US fiscal deficit above 7% of GDP over the next two years (Chart 2), even if most tariffs remain unchanged. Revenues find their way into government coffers.
Chart 2. The US deficit is already extremely large for this point in the cycle and will increase further
The risks are skewed towards an even larger worsening of the US deficit, in part because tariff revenues could be lower (the flip side of a less aggressive tariff policy, or faster trade re-routing), or because a greater share could be used to offset some of the damage caused by the trade war.
Markets may also have fiscal concerns elsewhere. European fiscal policy is being loosened to boost defense spending. The UK’s fiscal rules are likely to be broken again, given a limited appetite for higher taxes or lower spending. Japan may introduce additional stimulus measures following the upper house elections.
Long-end yields may therefore remain under pressure worldwide, as higher issuance is running into structurally lower demand from fully funded pension schemes.
All of this means the Federal Reserve (Fed) is in a challenging policy environment, facing pressures on both sides of its dual mandate, and financial markets are likely to remain skittish. We now expect the Fed to cut rates just once this year in December, as the moderating trade shock and still uncertain fiscal policy reinforce a wait-and-see approach. However, if the data deteriorates rapidly, more aggressive easing could be on the cards.
Elsewhere, the shock from US policy remains disinflationary. We expect this will spur one more cut by the ECB, taking policy below the neutral 2% mark. More cuts would occur if a 50% US tariff is confirmed on July 9.
The tariff détente achieved following the US-China meeting in Switzerland on May 11 means we now forecast a more gradual and modest sequential growth slowdown in China than previously. This will tone down the scale and urgency of further policy easing, but we still expect that the authorities will need to do more to support the economy.
The difficulty of securing a trade deal with the US, and existing legislation (Sections 232, 301) that provides an easy route for the US to raise tariffs on China, still points to decoupling being a long-lasting headwind to Chinese growth.
Emerging markets (EMs) have escaped relatively unscathed from recent pressure on DM long-end yields; the EMBI sovereign spread is little changed, for example. That said, EM policymakers still must contend with the uneven effects of US trade policy and market sensitivities to their fiscal slippage.
Stepping back, US exceptionalism remains under pressure. Indeed, the IEEPA court ruling serves as a reminder of the US's institutional strengths. However, the policy mix still suggests slowing potential growth, while uncertainty remains high.
Losing reserve currency status is still very unlikely, but policy mistakes - such as following through on Section 899 within the OBBBA, which threatens retaliatory taxes on foreign investments – risk souring foreign appetite for US assets.
US
Activity
Tariff policy has scrambled US GDP data. We are forecasting a strong Q2 rebound following the contraction in Q1. However, more fundamentally, given our base case expectation for the weighted average tariff rate to settle around 13%, we believe that elevated uncertainty (Chart 3) and lower real incomes will weigh on the cyclical growth outlook, while protectionism will dampen potential growth.
Chart 3. US uncertainty has spiked sharply and remains elevated even as the tariff rate has come down
Uncertainty is most likely to show up in hiring, investment, and durable goods purchases. We expect the budget reconciliation process to increase the fiscal deficit to around 7% of GDP; however, we believe higher yields will largely offset the stimulative impact.
Inflation
Ironically, trade policy may have had a disinflationary impact on recent inflation data due to lower portfolio management fees. However, the April inflation reports, which marked the second consecutive month of target-consistent inflation, are likely to indicate a local low. Even with tariffs expected to stabilize at a lower rate than previously thought, we believe the roughly 10% increase in the average tariff rate will create a sharp shock to goods prices. Given that inflation expectations have risen sharply, the risk of second-round price effects is considerable.
Policy
We believe that the risk of recession has moderated to around 30% over the next 12 months. With the Fed in wait-and-see mode, we now expect just one rate cut this year, in December. Should the data deteriorate more rapidly, more aggressive easing is possible, as the Fed is likely to be especially sensitive to a sudden weakening in the labor market. When Chair Jay Powell’s term expires in May next year, there is some risk that President Trump will appoint a chair who implements an inappropriately accommodative policy. Still, the immediate risk of Powell being sacked has faded.
Final thoughts
In conclusion, we believe the regime of US growth and market exceptionalism will remain under pressure, and further, the stakes for economic stability and investor confidence have rarely been higher. Long-term potential growth will slow, the policy environment looks structurally less stable, and US corporate moats may be shallower than previously thought. Reserve currency status is unlikely to be overturned. Still, an accumulation of policy mistakes – such as following through on Section 899 of the OBBBA, which threatens retaliatory taxes on foreign investments – could put it at risk.
1 "The 'major questions' Supreme Court hurdle that could stand in the way of Trump's tariffs." Yahoo! Finance, June 2025. https://finance.yahoo.com/news/the-major-questions-supreme-court-hurdle-that-could-stand-in-the-way-of-trumps-tariffs-080045814.html.
Important information
Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially.
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