The Hidden Risks of Tariff Policy: A Closer Look at Trade, Treasuries, and Market Stability
By Michael J. Willms | Independent Analyst1
Tariff changes have wide-ranging effects. Recent proposals to raise tariffs on imports could have ripple effects throughout financial markets, influencing trade flows, interest rates, and Treasury auctions.
Trade deficits support U.S. debt financing. U.S. trade deficits result in dollar outflows that often return as foreign investment in U.S. Treasuries—providing a key source of financing for federal deficits.
Coordinated policy is essential. Reducing the trade deficit without addressing the fiscal deficit could inadvertently disrupt Treasury markets, the economy and the stock and bond markets. A sequenced, integrated approach to fiscal and trade policy is critical.
Recent proposals for sharply higher tariffs on imported goods—particularly from China and Vietnam—have reignited debate over the effectiveness and consequences of aggressive trade policy. While the intent may be to narrow trade deficits and reshore domestic manufacturing, these measures risk producing unintended consequences in global capital markets and U.S. fiscal policy.
Tariff policy cannot be viewed in isolation. Like the old children’s song “Dem Bones,” where every bone is connected to another, the components of the global financial system are deeply intertwined. Tariff hikes affect trade flows, which in turn impact dollar liquidity, Treasury demand, interest rates, and ultimately financial stability. Attempting to eliminate the trade deficit without first addressing the fiscal deficit is like removing the femur bone and expecting the body to remain standing.
Markets Crave Clarity—And Tariff Uncertainty Isn’t Providing It
Markets tend to respond less to the fact of policy change and more to the uncertainty that surrounds it. Recent tariff actions have lacked detailed economic projections which have introduced significant uncertainty into global markets. As a result, the stock and bond markets have been left to speculate on both the intent and the outcomes of these policies.
With proposed tariffs on Chinese imports potentially exceeding 100%, market participants struggle to model the economic impact. This is not a trivial matter—exceedingly high tariffs may lead to a collapse in trade volumes, rendering corporate earnings projections based on existing trade flows misleading or meaningless.
Misunderstanding Tariff Revenue Potential
Some have estimated that raising tariffs could raise $250 billion to $600 billion in new revenue. Tariff proponents have also suggested that imposing a 145% tariff on Chinese goods could alone generate additional revenue of $636 billion These assumptions seem overly optimistic. According to the Office of Management and Budget, total tariff revenue in fiscal year 2024 amounted to just $80 billion.
In addition, these projections do not account for price elasticity or substitution effects. Simply put, if tariffs raise the cost of imported goods, consumers and industry can be expected to purchase more domestic goods. While this shift would encourage U.S. manufacturing, that growth would also correspondingly reduce tariff derived revenues.
The Overlooked Role of the Trade Deficit in Treasury Financing
An often overlooked but critical relationship exists between trade deficits and demand for U.S. Treasuries. In 2024, the U.S. trade deficit totaled $918.4 billion. When the U.S. runs a trade deficit, dollars flow abroad—many of which are reinvested into U.S. Treasury securities by foreign central banks and institutions. Without those dollars, this vital source of Treasury demand would likely be affected.
This dynamic creates a steady source of demand at Treasury auctions, helping to finance the federal deficit. Tariff policies designed to sharply reduce the trade deficit could inadvertently disrupt this cycle.
In short, reducing the trade deficit without first addressing the fiscal deficit risks, cutting off a key source of Treasury demand. Unless offset by spending reductions or new domestic buyers, the resulting increase in borrowing costs could potentially introduce further disruption in the bond markets and pose an additional threat to America’s fiscal stability.
Treasury Auction Warning Signs
Recent Treasury auctions have highlighted how delicate the balance has become. A weak $58 billion 3-year note auction required primary dealers to absorb more than 20% of the issuance—well above normal levels. The result prompted behind-the-scenes discussions in Washington and contributed to a temporary 90-day pause in the rollout of new tariff measures.
Treasuries rallied following the pause, and subsequent 10-year and 30-year auctions were well bid. However, the underlying concern remains: If foreign demand for Treasuries weakens due to a slowdown in dollar inflows from trade, future auctions may see increased volatility or worse yet, fail to attract sufficient buyers. Such a scenario would force the Federal Reserve to step in as a buyer of last resort—risking a new cycle of inflation and dollar devaluation.
The Sequence Matters: Trade Reform vs. Fiscal Discipline
Efforts to improve the U.S. trade balance are admirable and may yield long-term benefits. But policy sequencing is critical. A serious effort to realign trade flows must be paired with meaningful reductions in government spending or new sources of capital investment.
A coordinated approach—where fiscal policy, trade policy, and capital markets are aligned—is essential for ensuring sustainable outcomes. Without such coordination, tariff-driven trade disruptions could undermine America’s financial stability and creditworthiness.
The Milwaukee Company does not employ Mr. Willms. His views are his own and are shared here to encourage thoughtful discussion on trade and fiscal policy.