Weekly market wrap

New Bill, Old Burden: Fiscal Worries Resurface

Key Takeaways: 

• Stocks, bonds and the U.S. dollar all retreated last week amid renewed focus on the U.S. budget deficit and rising debt. Fresh tariff threats were also a reminder that trade developments remain in the driver's seat for global equities.
• The Moody's downgrade of U.S. government credit shines a spotlight on the growing debt burden. Yet, the decision does not impact the fundamental drivers of the economy and markets.
• The U.S. House of Representatives passed a new tax bill that extends existing tax cuts and includes new ones. The bill now moves to the Senate for debate and possible revisions. We expect a modestly stimulative fiscal policy supporting growth but also feeding into deficit concerns.
• The bill has potential implications for Canadian investors, as it may impact the withholding tax rates for Canadians holding U.S. dividend-paying securities. At this point we do not recommend taking any actions due to the potential revisions of this bill.
• While the trajectory of U.S. government debt is concerning, history shows that bond yields have not been influenced by Washington's spending habits. We find current yields attractive and expect the recent spike to be self-limiting.

After a more than 15% rally in the TSX and S&P 500 since the April 8 low, rising bond yields together with fresh tariff threats are now tapping the brakes on investor optimism. While trade developments have been widely covered, our focus here is on three additional catalysts behind the market's shift in tone: a U.S. credit-rating downgrade by Moody’s, a weak 20-year Treasury auction, and news that the U.S. House of Representatives passed a reconciliation bill—named the “One Big Beautiful Bill”—which extends expiring tax cuts and proposes new ones. It also includes potential implications for Canadians. While passage in the House is a milestone, the bill now moves to the Senate for debate and possible revisions.

Meanwhile, the 30-year U.S. Treasury yield climbed above 5%, the dollar weakened against loonie, and equities pulled back amid renewed focus on the U.S. budget deficit and rising debt levels¹. Though the trigger was new, the underlying concern about fiscal sustainability is not. The question now appears to be whether these developments mark a turning point for markets, or simply a temporary pause, and what signals the bond market is sending.

Trio complete: Moody's aligns with S&P and Fitch in U.S. credit downgrade

Moody's became the last of the "Big Three" rating agencies to downgrade U.S. debt, citing a lack of progress from numerous past Congresses and administrations to address rising fiscal deficits, and growing interest costs as a percentage of GDP. The one-notch downgrade means that the U.S. lost its last triple-A credit rating after Standard & Poor's (S&P) took similar action in 2011 and Fitch in 2023¹.

Nearly 15 years ago when the S&P made the same decision, the market reaction was swift, with volatility spiking and equities pulling back. However, last week's action was hardly a surprise, in our view, as Moody's had the U.S. on negative watch since November 2023 and its downgrade simply matched the rating of the other two agencies. Major index providers had already moved U.S. government bonds to the double-A bucket, as they either use the middle rating or the lowest (worst) of the three to determine index eligibility. This is why the latest downgrade won't trigger forced selling of Treasuries by passive funds that track these indexes. 

The upshot is that the Moody's move doesn’t have any direct market implications in our view, but it does shine the spotlight on the worsening fiscal outlook at a time when Congress is in the process of passing a bill that is expected to push deficits higher for the remainder of the decade. 

House Passes "Big, Beautiful" tax bill – On to the Senate

On May 22 the U.S. House passed the reconciliation bill by one vote, the narrowest of margins. The bill primarily extends the 2017 current tax cuts and includes additional proposals that were highlighted during the Trump campaign. To help cover the cost of the tax proposals, the draft bill included several provisions to raise revenue, When netting out the tax cuts, new spending, revenue provisions, and additional interest-rate cost, the Congressional Budget Office estimates that the bill would add nearly $3 trillion to the U.S. budget deficit over the next decade.

Many of the tax cuts are front-loaded, designed to be in force from 2025 to 2028, while and the spending cuts are backloaded, likely pushing the deficit to 7% of GDP in the next two years². The likely increasing deficit is mathematically a positive from an economic standpoint, adding to GDP, though its impact is likely to be partly offset by the drag from tariffs. We expect a modestly stimulative fiscal policy supporting growth but also feeding into deficit concerns. However, we would highlight that the final bill could look very different than the House version that was just passed. This is likely the start of a long process, with Congress setting a goal of a final bill signed into law on July 4.

Why Canadians should pay close attention

The far-reaching bill includes a section that could impact the withholding tax applied to dividends paid to Canadians by U.S. corporations. While the proposed bill may still change as it moves through the Senate, it is worth keeping an eye on. The U.S. bill proposes tax changes to countries it deems to impose unfair foreign taxes on its people and businesses. The bill would authorize the U.S. Treasury Secretary to designate these countries as a "discriminatory foreign country". Under that designation, the U.S. can choose to enact changes to previously established withholding tax rates on U.S. source income, overriding the tax treaty that’s been in place since 1942. Dividends, interest and royalties received from U.S. companies could see the withholding tax rate increased to as high as 50% in as little as four years.

Canada may be particularly at risk of becoming designated as discriminatory in part because of the digital services tax (DST) that was introduced in June 2024. The DST applies a rate of 3% on revenue earned from certain digital services that rely on engagement, data, and content contributions of Canadian users and certain sales or licensing of Canadian user data.

Canadian corporations that receive dividends from U.S. subsidiaries are currently subject to a 5% withholding rate under the existing treaty. If the proposed changes go through, this tax rate would increase by 5% per year until it reaches 20% above the current statutory rate of 30%. Because the final bill could look very different than the initial drafts, we do not recommend taking any actions at the moment. 

Rise in bond yields – A reduced U.S. credit-worthiness story, or something else?

The 10-year U.S. Treasury yield exceeded 4.5% last week and the 30-year crossed the 5% mark, nearing the highest since 2007¹. In Canada, the 10-year jumped briefly to 3.40%, the highest since January. These moves potentially send a warning signal that the bond market is starting to pay attention to the U.S. government's debt trajectory and fiscal discipline. Rising borrowing needs may affect long-term Treasuries more than short-term bonds, steepening the yield curve, as investors require additional yield (a risk premium) to hold long-term debt. In our view, the recent jump in yields partly reflects these emerging concerns, as highlighted by the Moody's downgrade. However, we think there is more to the yield story.

As the administration has softened its stance on trade (at least up until last Friday), the odds of a recession have fallen, and stocks have made a roundtrip, returning where they were at the start of the year. Similarly for the bond market, reduced headwinds to growth, together with upcoming fiscal stimulus, have led to a recalibration in Fed rate-cut expectations. Bond markets once again expect only two or fewer rate cuts this year, and the 10-year Treasury yield is back to where it started the year¹. Longer-term U.S. bond yields are higher, but that has been a global move. The 30-year yield on Japanese bonds last week hit the highest on record, and long-term bonds in Germany, the U.K. and Australia were also under pressure¹.

Portfolio tip: We prefer the seven to-10-year bond segment instead of the 10+, but we think that bond yields are currently attractive. For maturing GICs and portfolios with an oversized allocation to cash-like investments, we recommend considering intermediate- and long-term bonds to lock in the higher yields for longer. In our view, the rise in bond yields is self-limiting, as higher yields 1) attract more demand; 2) slow economic activity and inflation, leading the Fed to reconsider rate cuts; and 3) may prompt policy changes with lawmakers pulling back on some spending initiatives or adding offsets.

Do high deficits and debt matter for investors?

Trend is worrisome: 10 years ago, the U.S. federal deficit was $472 billion, or about 3% of GDP. By 2019, after the 2017 tax cuts and before the pandemic, the deficit had jumped to $984 billion, or 4.6% of GDP. And last year, the deficit was $2 trillion, or 6.7% of GDP. During this timeframe the S&P 500 has returned 230%, including dividends¹. 

However, the numbers are getting more challenging. Even before the new tax bill, the CBO was projecting that the debt-to-GDP ratio could reach a record high of 150% of GDP within the next 10 years. With interest rates still high, interest costs to service the existing debt are becoming a larger burden to the budget. At 3% currently, interest payments on federal debt as a percent of U.S. GDP are matching the highs of the late-1980s and early-1990s¹.

The government vs. the rest of us - No doubt the fast-increasing deficits and federal debt at a time when the economy is expanding and unemployment is historically low are concerning. But unlike corporations and households, the U.S. government is borrowing in its own currency, which it issues, and it can also roll over the debt indefinitely. Though it cannot run out of money in the same way that a company or an individual would, printing too much money can lead to inflation. While fiscal concerns are not new and are not going away anytime soon, we don’t see the debt situation being a near-term threat to the economy, but we do believe it will require tough fiscal choices down the road. A combination of tax hikes and spending cuts or potential adjustments to entitlement programs, such as Social Security, are likely.

Treasuries are still a safe asset - Despite the challenges, we think U.S. Treasuries remain the world's premier safe asset. That is not because of the U.S. debt's credit rating, but because of the Treasury market's enormous liquidity and market depth, allowing international investors to store money and invest in the government debt of the largest economy, whose currency is the world's reserve. For now, there is no other asset class to act as a realistic alternative, in our view. It's also worth noting that Japan, China and the United Kingdom all have government debt that is a higher percentage of GDP.

A review of the historical relationship between bond yields and debt levels for large-advanced economies reveals that a rising debt/GDP ratio has not coincided with higher bond yields, and in fact it's been the opposite. When the government was running a surplus between 1997 and 2001 under the Clinton administration, the 10-year yield hovered around 6%, while during in the post-pandemic years yields fell to record lows despite deficits exploding¹. That is not downplaying the need for fiscal restraint, but it appears to highlight the importance of considering the economic growth and Fed policy regimes that are still the primary driver of yields. 

The bottom line - Deficits and debt matter for investors, but more so from a financial planning perspective as taxes are currently historically low (investors may want to consider proactive tax strategies before potential increases), and less from a portfolio standpoint, in our view.

Fresh tariff threats are a reminder that trade is still in the driver's seat

The threats of 50% tariffs on the European Union and a 25% levy on Apple late in the week acted as a reminder that trade developments remain the No. 1 issue for the markets. With stocks enjoying a strong run over the past two months, the negative reaction to the news was not surprising. On the other hand, yields retreated, and bond prices rose.

We think that near-term market gains may be harder to achieve. Because many tariffs are paused rather than removed, we are not out of the woods yet. The 90-day pause on the initial tariffs is set to expire in July, while the lower tariffs on China expire in August. These deadlines also coincide with the U.S. debt-ceiling stand-off, which could add to market volatility. While we expect a resolution, it may not come until the last minute. 

Overall, we still believe that peak uncertainty is behind us as the negotiating process kicks into high gear. Also, history offers some encouraging perspective. Strong rallies like those seen since the April 8 lows are often followed by continued positive returns. The trailing one-month monthly gain ranks as the fifth strongest in the past 40 years. While follow-through over the next month can be mixed, historical trends suggest that 12-month returns following rallies of this magnitude have been solid³.

We recommend that investors dollar-cost average to take advantage of market swings, focus on diversification, and properly ladder fixed-income holdings to benefit from the potential for lower yields in 2026.

Angelo Kourkafas, CFA
Investment Strategist

^{Sources: 1. Bloomberg 2. Congressional Budget Office and CRFB estimates 3. FactSet, Edward Jones}

Weekly market stats

Source: FactSet, 5/23/2025. Bonds represented by the Bloomberg Canada Aggregate Bond Index. Past performance does not guarantee future results. *4-day performance ending on Thursday.

The Week Ahead

Important economic releases this week include domestic first-quarter GDP and U.S. PCE inflation.