How Tariffs & Debt Are Reshaping the Economic Landscape

The U.S. economy is navigating a complex interplay of persistent tariffs and mounting national debt, creating a stagflationary environment where price pressures rise even as growth indicators soften. Investors must brace for continued market volatility driven by these twin forces, with critical data on employment and inflation holding the key to future Federal Reserve policy and market direction.

Key Insights

1. Tariffs: From Abstract Threat to Tangible Economic Drag

Liz Ann Sonders highlights that the economic impact of tariffs is no longer theoretical but is actively filtering into key economic data, signaling a slowdown.

"I think we are finally starting to see it infiltrate some of the numbers. We've seen it in many of the regional Fed surveys in terms of pricing components. We saw it in the somewhat surprising release by Institute of Supply Management, the ISM non manufacturing...that moved down into contraction territory which was not expected...the price is paid component continues to be spiking higher." - Liz Ann Sonders

The discussion underscores a shift from anticipating tariff effects to observing them. Liz Ann Sonders points to a mid-teens average effective tariff rate (inclusive of IPA tariffs) that is now manifesting in economic reports. The ISM non-manufacturing (services) index unexpectedly fell into contraction, mirroring the already struggling manufacturing sector. Crucially, the "prices paid" component within these surveys is surging, indicating businesses are facing higher input costs, largely due to tariffs. This creates a "stagflationary impulse"—slowing growth accompanied by rising prices.

Furthermore, Sonders notes emerging weakness in the labor market, with initial unemployment claims rising more than expected and layoff announcements increasing. This suggests that businesses, squeezed by tariffs and slowing demand, may be starting to shed workers. The uncertainty surrounding the International Emergency Economic Powers Act (IEEPA) tariffs, potentially heading to the Supreme Court, only adds to the precarious environment, making it difficult for businesses to plan and invest.

Actionable Takeaway: Investors should monitor high-frequency labor market data (initial claims, layoff announcements) and pricing components in business surveys (ISM, regional Fed) for early signs of further economic deterioration or persistent inflation driven by tariffs. Sectors with high import exposure and thin margins may be particularly vulnerable.

2. The "One Big Beautiful Bill Act" & The Soaring Deficit: A Financing Challenge Looms

Both Liz Ann Sonders and Kathy Jones express concern over the significant increase in the national deficit projected from upcoming budget legislation, with estimates ranging from $2.4 trillion to $4 trillion over 10 years.

"But between the CBO or the Congressional Budget Office and the Yale Budget Lab...it looks like it's going to add anywhere from 2.4 trillion to 4 trillion to the deficit over 10 years, depending on what assumptions you make. And that's a lot. That's going to mean a lot of financing in the debt markets and the treasury market." - Kathy Jones

The proposed budget bill, ironically titled the "One Big Beautiful Bill Act," is set to substantially increase U.S. debt. Liz Ann Sonders questions the reliability of CBO estimates that tariff revenue will offset a significant portion of this new spending, given the high uncertainty surrounding future tariff policies and revenue streams. Kathy Jones elaborates on the financing implications, noting that while shorter-maturity Treasury yields (2-5 years) are closely tied to Fed policy expectations, longer-maturity yields are more sensitive to supply and demand dynamics.

The sheer volume of new debt issuance required will test the Treasury market's absorption capacity, particularly at the long end where the buyer base (pension funds, insurance companies, foreign governments) is narrower. This increased supply could put upward pressure on long-term interest rates, independent of Fed actions. The ongoing trade conflicts with major Treasury holders like China and Japan further complicate the financing picture, potentially discouraging them from accumulating more U.S. debt.

Actionable Takeaway: Investors should watch Treasury auction results, particularly for longer-dated bonds, and foreign holdings data for signs of waning demand. A steepening yield curve driven by rising long-term rates (while short-term rates are anchored by Fed expectations) could signal market stress about debt sustainability and inflation.

3. U.S. Debt: No Imminent Default, But a Growing Fiscal Strain

Kathy Jones reassures that despite the mounting debt, the U.S. is not on the brink of default, but emphasizes the significant strain that rising interest payments place on the federal budget.

"Are we going to default on our debt or are we going to run out of money? Is this going to be an implosion of the treasury market? And I think that that kind of conclusion is really overblown. We are not going broke...We have the capacity to finance our debt and I have no doubts that we will continue to finance our debt." - Kathy Jones

While dismissing fears of an outright U.S. default due to the nation's economic size and wealth, Jones highlights a critical consequence of high debt levels: the growing portion of the budget consumed by interest expense. This crowds out other potential uses of funds, whether for tax cuts or increased spending on other priorities, leading to contentious political battles. The inability to rely on significantly lower long-term yields, which are market-driven by supply and demand, exacerbates this problem.

The current trade disputes with major creditors like China and Japan add another layer of complexity, as these nations might be less inclined to increase their holdings of U.S. Treasuries. This dynamic creates a "swirling in a loop" scenario in the Treasury market, characterized by range-bound trading until clearer economic signals emerge that could prompt a decisive Fed move.

Actionable Takeaway: While default risk is low, investors should consider the long-term implications of rising debt service costs on fiscal flexibility and potential inflationary pressures if debt monetization becomes a more prominent policy tool. This could favor assets that offer inflation protection.

4. Labor Market and Inflation: The Twin Pillars of Fed Policy

Both analysts agree that the upcoming jobs report, alongside CPI and PPI inflation data, will be pivotal in shaping the Federal Reserve's next moves, with the labor market holding particular sway.

"I think the labor market absolutely holds the key. It holds the key for the consumption side of the economy and to a large degree it holds the key for Fed policy because I think that's more the needle mover, the labor market side of their mandate in terms of justifying a move back toward cutting interest rates." - Liz Ann Sonders

Liz Ann Sonders emphasizes that the labor market is critical not only for consumer spending (the backbone of the U.S. economy) but also as the primary factor influencing the Fed's decision-making regarding interest rate cuts. While the consensus for the upcoming jobs report was around 130,000, she noted a "whisper number" trending lower, especially after higher-than-expected unemployment claims and continuing claims at a cycle high. A significantly weak jobs report could provide the justification the Fed needs to begin easing monetary policy.

Kathy Jones concurs, adding that softening inflation figures would also support the case for rate cuts. She maintains an expectation for the Fed to cut rates in September, with a potential for another cut towards the end of the year, contingent on evolving economic data. The University of Michigan's consumer sentiment survey, particularly its inflation expectations component, is another key data point the Fed monitors closely.

Actionable Takeaway: Investors should prepare for heightened market volatility around key employment and inflation releases. A weaker-than-expected jobs report or a significant drop in inflation could accelerate expectations for Fed rate cuts, potentially benefiting rate-sensitive assets and growth stocks. Conversely, persistent strength could delay cuts and favor value or defensive positioning.

5. Tariffs' Inflationary Sting: Challenging Textbook Economics

Contrary to some theoretical expectations, tariffs are proving to be inflationary, with costs largely passed on to U.S. consumers, and are not being offset by currency movements as some models might predict.

"The US Company pays the tariff and then most of it...does get passed on to consumers. There's no major eating of it in profit margins, certainly not among retailers which operate with very narrow profit margins." - Liz Ann Sonders

Liz Ann Sonders refutes the notion that targeted countries absorb tariff costs by lowering their prices. Instead, U.S. importing companies pay the tariffs, and these costs are largely passed on to consumers, a finding supported by a New York Fed study. This is especially true for sectors like retail, which operate on thin margins and cannot easily absorb such increases.

Adding to this, Kathy Jones points out an unexpected currency dynamic. Instead of the U.S. dollar strengthening (which would theoretically help offset tariff costs for importers), the dollar, on a trade-weighted basis against import partners, is near a three-year low. This depreciation further exacerbates inflationary pressures from tariffs. The combination of rising unit labor costs and negative productivity, as highlighted by Liz Ann Sonders, adds another layer of concern to the inflation outlook, creating an unfavorable economic mix.

Actionable Takeaway: The pass-through of tariff costs suggests sustained pressure on consumer prices. Investors should consider sectors with pricing power or those less exposed to import costs. The weakening dollar, if it persists, could benefit U.S. exporters and multinational corporations with significant overseas earnings, while also contributing to domestic inflation.

6. The Fog of Data: Budget Cuts Impair Economic Visibility

A critical, yet often overlooked, challenge is the deteriorating quality and completeness of essential economic data due to budget cutbacks at government agencies.

"The various government agencies that gather information are feeling the pinch from the cutbacks and we're not getting data gathered for CPI from certain metropolitan areas now. And similar story is going to be the case in the labor market. So we're actually getting less complete and potentially accurate data now..." - Kathy Jones

Kathy Jones raises a crucial concern: at a time when accurate economic data is paramount for policymaking and investment decisions, the agencies responsible for collecting this information are facing resource constraints. This is leading to gaps in data collection, such as certain metropolitan areas no longer being included in CPI calculations, and similar issues are anticipated for labor market statistics.

This reduction in data integrity means that policymakers, including the Federal Reserve, and market participants may be operating with a less clear picture of the true state of the economy. This can lead to misjudgments in policy responses and increased uncertainty for investors trying to navigate complex market conditions. The revisions to data, already a common feature, may become even more significant and potentially market-moving.

Actionable Takeaway: Investors should be aware that headline economic data might be subject to greater revisions or may not fully capture underlying trends. This uncertainty premium could lead to increased market volatility. Relying on a broader array of indicators, including private sector surveys and alternative data sources, may become more important for forming a comprehensive economic view.

Notable Quotes

Liz Ann Sonders: "I think the labor market absolutely holds the key. It holds the key for the consumption side of the economy and to a large degree it holds the key for Fed policy because I think that's more the needle mover, the labor market side of their mandate in terms of justifying a move back toward cutting interest rates."

Kathy Jones: "We are not going broke. We're the largest economy in the world. We're a very wealthy country. I always say this. We have the capacity to finance our debt and I have no doubts that we will continue to finance our debt. But it puts obviously a strain on the budget to have so much going to interest payments rather than to other things."

Liz Ann Sonders on who pays tariffs: "The US Company pays the tariff and then most of it...does get passed on to consumers. There's no major eating of it in profit margins, certainly not among retailers which operate with very narrow profit margins."

Market Implications

The discussion between Liz Ann Sonders and Kathy Jones paints a picture of an economy grappling with significant headwinds from both tariffs and a burgeoning national debt. The primary market implication is sustained volatility as investors decipher the stagflationary signals: tariffs pushing prices up while potentially slowing growth, and massive Treasury issuance testing market appetite for U.S. debt.

Investment Strategies to Consider:

1. Navigating Stagflationary Pressures:

   • The combination of slowing growth (evidenced by ISM contractions and weakening labor signals) and persistent price pressures (from tariffs and supply chain issues) suggests a challenging environment.
   • Action: Investors might consider assets that historically perform well in inflationary environments, such as commodities or real assets, and companies with strong pricing power that can pass on increased costs. Caution is warranted for sectors highly sensitive to consumer discretionary spending if the labor market continues to soften.

2. Fixed Income Focus on Fed Policy and Supply:

   • The Treasury market will be a key battleground. Shorter-term yields will remain tethered to Fed expectations (Kathy Jones anticipates cuts starting September), while longer-term yields will be influenced by the sheer volume of debt issuance.
   • Action: A barbell strategy in fixed income could be considered, balancing shorter-duration instruments sensitive to Fed cuts with a cautious approach to long-duration bonds, given the supply overhang. Watching foreign demand for Treasuries will be crucial.

3. Currency Dynamics:

   • The unexpected weakness in the U.S. dollar on a trade-weighted basis, as highlighted by Kathy Jones, adds another layer to the inflation narrative.
   • Action: A weaker dollar could benefit U.S. companies with significant overseas earnings and make U.S. exports more competitive. It may also make foreign assets relatively more attractive for U.S. dollar-based investors.

4. Data Dependency and Fed Watching:

   • With the labor market and inflation data being paramount for Fed decisions, markets will likely experience heightened sensitivity around these releases. The potential for less reliable data, as Kathy Jones warned, adds an extra layer of uncertainty.
   • Action: Investors should brace for sharp reactions to economic reports. A defensive or nimble posture might be advantageous, allowing for adjustments as the Fed's path becomes clearer. Sectors sensitive to interest rate changes (e.g., financials, real estate, growth technology) will be particularly reactive.

The core message is that the economic landscape is being actively reshaped by fiscal and trade policies. Understanding the direct impacts (e.g., tariffs on prices) and indirect consequences (e.g., debt financing on interest rates) is crucial for investors seeking to protect capital and identify opportunities in this evolving environment.