We tend to focus on which country is top dog, but perhaps we should think about debt and compound interest as the apex predators in all this.

When President Trump suspended tariffs on the the 9th April, he pointedly left the new 145% tariffs on China in place, and in so doing, revealed the identity of America’s main enemy. Talks this past weekend have now seen the majority of both China and America’s new tariffs suspended for a period of 90 days. Cue triumphalism in the White House and talks of reconciliation from Beijing.

The stock market is naturally celebrating this trade war detente, even if it is really only a suspension which some analysts, including Moody’s, are suggesting is just a window in which both sides prepare and adapt their supply chains for round two of the fight¹ .

Yet While equities roof, global bond markets have seen a worrying rise in yields this week. In part this is due to the pricing out of rate cuts – the Fed is now seen as cutting only twice this year – as inflation expectations rise with the odds of a recession falling.

US 10yr yields are up 13 basis points on the week, with the 30yr now yielding almost 5%. The Japanese 30yr is touching 3% for the first time in decades, and other developed market paper is pushing higher too. 

President Bill Clinton’s former political advisor James Carville once said he’d love to be reincarnated as the bond market because “you can intimidate everybody”. Geopolitics and statecraft notwithstanding, is it debt that’s showing main character energy in 2025, while President Trump, Secretary of State Bessent and friends are being relegated to NPC roles?

It was the debt markets which forced the Trump tariff U-turn (photo source: Forbes Magazine).

Much like former UK Prime Minister Liz Truss’ suicidal tax-cut driven budget in 2022, President Trump’s gung-ho tariff explosion at the start of April fell foul of a collapse in bond prices. 10yr Treasury yields rose nearly 50 bps in a week, and it was this, rather than equities dumping or the dollar weakening, which forced the White House into its first 90-day tariff suspension.

The Republicans are currently pushing through a Ways & Means bill which includes a plan to roll the 2017 tax cuts due to expire at the end of the year, a smart move to avoid an unnecessary tightening of fiscal policy. The bill also includes plans to reduce spending by $1.5 trillion, with a goal of cutting it by $2 trillion over 10 years. 

Whether this is realistic or not is a different matter; all of a sudden, DOGE has gone a little quiet, and even if its $160 billion of announced savings are real, it falls well short of the election promise of $2 trillion.

Looking at US Federal accounts for the first 6 months of the financial year, revenues grew 4.9% to $3.1 trillion, while spending rose 9% to $4.1 trillion. The total deficit grew 22% to $1.05 trillion. Annualise that, and you have a number around $2 trillion. 

Spending cuts, deregulation and growth-focused policies clearly have a lot of heavy lifting to do, especially as the bulk of federal expenditure is on politically sensitive areas such as Medicare, Medicaid, veterans benefits and defence.

Federal interest expenses in the first half were $578 billion, up 12.7% year-on-year. With $9 trillion of refinancing this year, and with the Federal Reserve seemingly on hold due to tariff-related inflation uncertainty, even refinancing the debt at the short end of the yield curve is going to put the goal of deficit reduction under severe pressure.

With US debt-to-GDP at 124%, the swing factor in the deficit is the financing cost. Perhaps efficiencies can shave a few hundred billion of the deficit figure, but if interest expenses continue to rise, and even if the US doesn’t go into recession (a situation which will cause the deficit to explode), then at best we are still talking a high single-digit primary deficit for the foreseeable future. 

It’s starting to look like debt is driving the car at this stage. The Republican plan to raise the debt ceiling by another $4 trillion is just a reflection of the reality of who (or what) is really in charge².

Not a Schwabian housewife. German Finance Minister Lars Klingbeil (photo source: Bundesfinanzministerium).

While the Americans have always been pretty free and easy about giving it a try and using debt to do so, over in Germany, the country’s deep memory of 20th century hyperinflations have always made it more cautious when it comes to indebtedness. 

With debt-to-GDP at 62%, Germany doesn’t exactly follow Laertes advise to ‘neither a borrower nor a lender be’ to the letter, but the 2009 debt break rule (limiting the deficit to 0.35% of GDP) reflects a mindset where a balanced budget was always seen as an economically prudent if not a morally worthy achievement.

All this is changing as Germany tries to stimulate its moribund economy with a €1 trillion spending plan which analysts believe will not only push its debt-to-GDP to the 80% level, but which will also put the country into conflict with the EU and the terms of Stability and Growth Pact³.

Debt spent on investment, whether it is at a personal level (for example student loans) or at a corporate level (for R&D or capital investment more generally) is generally a good thing if it leads to economic growth. Debt spent on consumption simply means a short term rush followed by higher interest expenses due to a less sustainable stock of debt. Germany’s plan to focus on military spending is very much the latter, as guns and ammo are dead money once they’ve been manufactured.

It is a basic truth of markets that debt grows because interest compounds, and the debt jubilees of the ancient world, involving periodic write-off’s of outstanding loans to rebalance society, are not really an option in the modern world of international capital flows and floating currencies. What happens now is that as the interest rates of countries like Germany and Japan rise, so does the global interest rate floor. Financing costs increase, interest compounds faster and debt grows more quickly. More pressure is then put on productivity to keep nominal GDP growing in order to offset this.

Aside from productivity growth from investment (which is a factor in the private not the public sector of the economy), governments can reduce debt-to-GDP in any of four ways. First, they can cut spending via austerity, which is a vote loser. They can increase taxes, which is bad for private-sector growth. They can default, which is a death-wish move for a floating currency (see Russia in 1998), or they can inflate the debt away. 

Given the ease with which those who control a nation’s currency can debase it, history shows it’s the last option which tends to be chosen. Perhaps this explains the renewed interest in gold and the rise of Bitcoin, as markets sniff out the inevitability of the plans which will likely have to be implemented if governments get serious about wrestling control of their economies away from the force that is debt and compound interest.

References

1. William Langley et al, China’s exporters crank back into gear, Financial Times, 15/05/2025.

2. Aris Folley, House GOP unveils plan to raise debt limit by $4 trillion, The Hill, 12/05/2025.

3. Anne-Sylvaine Chasany and Paola Tamma, EU champion of fiscal rules prepares to break them, Financial Times, 13/05/2025.

This article was originally published on Market Depth.