The combination of a reduced headwind from tariffs and a reversal of tighter financial conditions from their April peak has reduced risks to U.S. growth. Given that inflation is still likely to reaccelerate, the baseline scenario for further rate cuts by the Federal Reserve (Fed) has shifted to a later and more leisurely pace than previously forecast, with a resumption of cuts likely by the end of 2025.

This combination of positive (albeit below potential) growth of positive growth (albeit below potential), inflation above the Fed's target and reduced room for further monetary easing in the near term has contributed to the increase in interest rates in recent weeks. has contributed to the increase in interest rates in recent weeks.

However, we believe that this "more conventional" explanation is is "falls short of explaining the sharp rise in yields at the long end of the curve and the steepening of the curve.

The underlying problem is high fiscal deficits

• The United States has accumulated a huge budget deficitas interest costs on Treasury debt have continued to rise due to a combination of higher rates and higher principal borrowing. The fiscal deficit so far this fiscal year already stands at $1.05 trillion, up 13% from the previous year. Tariff revenues helped reduce some of the imbalance last month.
• This led Moody's late last week to downgrade the U.S. sovereign credit rating by one notch, from Aaa (the highest possible) to Aa1citing the growing burden of financing the federal government's budget deficit and the rising cost of rolling over existing debt in a high interest rate environment.
• With this, the US has lost its last remaining triple-A rating, following in the footsteps of Fitch in 2023 and S&P in 2011. While we could say that this was relatively expected by the market and therefore incorporated, what is important for the bond market is the underlying message: concerns about higher structural deficits in the US, against a backdrop of heightened political uncertainty, could cause the Treasury curve to continue to steepen in the near term. This downgrade supports a higher term premium in the longer term..

• The focus is now on Washington, as the tax bill could come before the full House of Representatives for a vote in the coming days. In this regard, Moody's notes that "if the Tax Cut and Jobs Act of 2017, which is the base case, is extended, it will add about US$4 trillion to the federal primary fiscal deficit (excluding interest payments) over the next decade."
• As a result, federal deficits are projected to widen, reaching almost 9% of GDP by 2035, up from 6.4% in 2024. This increase would be driven primarily by rising debt interest payments, increased spending on social benefits, and relatively low revenue generation. Moody's projects that the federal debt burden will amount to approximately 134% of GDP in 2035, compared to 98% in 2024, figures that are fairly in line with some estimates we have previously reviewed.
• In addition, it is important to note that, according to the text of the bill released this week by the House of Representatives, new borrowing is front-loaded, while offsets are back-loaded. Therefore, the deficit impact is projected to be higher in the short term and lower starting in 2029.

• But the problem is not just a U.S. problem. Long-term financing costs are also rising in other major economies, as the combination of lower demand for long-term and higher supply - aimed at covering massive budget deficits - particularly in Japan, the US and the UK, appears to be affecting valuations at the long end of yield curves.
• Thirty-year bond yields in the U.S. traded above 5% this week, not far from their highest level since 2007, while those in Japan reached their highest level since records began in 1999. In both countries this week's auctions reflected weak demand.

• The sell-off in long-maturity Japanese bonds is particularly acute. The Bank of Japan is reducing its bond purchases as inflation accelerates, but traditional buyers-such as insurance companies-are not filling the gap this leaves. This deterioration in Japanese bond market liquidity, which could lead to "disorderly increases" in longer-term yields, is not just a problem for Japan, is not just a problem for Japan: it also leaves US and global assets exposed to corrections.

• The increase in public borrowing costs also has an impact on companies and households, which face higher interest rates, thus limiting their borrowing or spending capacity, which face higher interest rates, thus limiting their borrowing or spending capacity. This generates a vicious circle in which budget deficits rise further due to falling tax revenues. Central banks may be forced to decide whether to shift their attention from inflation to economic growth.

• But it is precisely this "potential vicious circle" that could put a certain ceiling on Treasuries, as higher rates, at the end of the day, translate into tighter financial conditions that sap growth and corporate earnings.But it is precisely this "potential vicious circle" that could put a certain ceiling on Treasuries, since higher rates, at the end of the day, translate into tighter financial conditions that undermine growth and corporate earnings. We believe, however, that this "ceiling" could be somewhat closer to 5% for the 10-year Treasury. In the meantime, maintain a fixed-income strategy in the short-to-mid end of the curve in corporate bonds. Investment grade.

• What about stocks? As we raised last week, given the market's already optimistic pricing on the outlook for economic and corporate earnings growth, as well as uncertainty around the magnitude of a potential slowdown in both growth and corporate earnings - compounded by higher discount rates, we believe this is likely to keep a lid on equity multiples over the coming months (see analysis). Moreover, this scenario could well be the trigger for further corrections, as the increase in yields demanded by investors to purchase US Treasury debt, reflecting higher risk, could weaken the appetite for US assets, including equities.

Finally, at the local level, although we have "a certain amount of slack", our debt capacity is "at the limit", our borrowing capacity is "at the limit", which does not invite complacency..

DISCLAIMER

Humberto Mora

Investment, Finance, and Business Manager; Stockbroker