May 01, 2025

Tariff Blindspot — Higher Rates and a Weaker Dollar

Senior Advisor to Lime Fintech

While markets have remained focused on the direct impact of tariffs ranging from lost foreign revenue to cost inflation and delayed capital investment, there is a potential for more consequential, longer-term effects in higher interest rates and a weaker dollar.

Lower Trade → Higher Yields → A Weaker Dollar

The U.S. has long benefitted from a virtuous cycle: it runs a trade deficit, and in return, trade-surplus countries recycle export proceeds by purchasing U.S. Treasury securities and dollar-denominated assets. This dynamic has helped suppress yields and stabilize the dollar for decades.

Tariffs, however, have disrupted this balance.

Foreign central banks, particularly those in trade-surplus economies, accumulate reserves through net exports and generally channel those dollars into U.S. Treasuries. Today, foreign investors hold ~25% of Treasury debt, and another 25% of government-sponsored entities (GSE) debt from agencies like Fannie Mae and Freddie Mac. This foreign demand has historically helped maintain low borrowing costs across the U.S. economy – from mortgages and credit cards to municipal bonds and corporate credit.

But if trade volumes shrink, so too does the reserve accumulation that underpins this capital recycling. And with that, ensuing demand for Treasuries may weaken, causing yields to rise.

Moreover, sovereign wealth funds in countries like Norway, Saudi Arabia, and Singapore invest trade surpluses in broader dollar assets (e.g., equities, private markets, and real estate). A reduction in trade flows implies reduced sovereign fund inflows, further pressuring the dollar and long-dated U.S. assets.

We're already seeing the impact: the dollar has depreciated over 10% year-to-date against other major currencies.

Policy Volatility May Fade, But the Yield Shock Stays

Much of the market’s reaction has centered on the unpredictability of trade policy, with shifting tariff schedules, exemptions, and contradictory statements. While this uncertainty is disruptive, the structural impact on U.S. capital flows may pose a bigger threat.

The U.S. currently faces a $2 trillion fiscal deficit and must refinance about $9 trillion in maturing debt this year. That puts total gross issuance needs at ~$11 trillion, one of the largest debt supply waves in history.

Even if trade policy stabilizes, the Treasury must roll over bonds issued during lower-rate periods at today’s higher yields. It can be estimated that this rollover alone will add $150 billion to $200 billion in annual interest expense, or 0.65%–0.80% of GDP. If Treasury yields continue rising due to diminished foreign demand or credit risk repricing, this would escalate costs.

Additionally, larger deficits and weaker demand could lead to rating downgrades, pushing institutional investors to demand higher premiums for U.S. debt, further embedding a high-yield regime.

Currency Depreciation Risks U.S. Capital Formation

A weakening dollar is also a drag on capital investment. In emerging markets (which offer ample case studies for the current scenario in the US), sustained currency depreciation typically coincides with reduced foreign direct investment (FDI) and capital formation. Long-term investors prioritize currency stability when evaluating projects that require multi-decade payback periods.

The U.S. is projected to need to invest roughly 17%–20% of GDP annually in capital formation just to maintain production capacity. At the low end of that range, capital investment merely replaces depreciated assets. A weaker dollar, combined with elevated funding costs, would jeopardize that threshold, risking a drag on productivity and future growth.

Defensive Positioning Tactics Seen in the Market

In a cautious market environment, traders may desire to adopt a more conservative stance. Such approaches may include:

> Maintaining higher cash allocations

> Allocating to very short-duration fixed income instruments

> Focusing equity exposure on traditionally defensive sectors, particularly companies with:

Solid free cash flow generation
Limited exposure to global trade dynamics
Resilience to interest rate shifts (e.g., property and casualty insurers, utilities)

Despite the recent pullback, the S&P 500 still trades above 19x forward earnings, which can be viewed as elevated given macro headwinds. Select opportunities may emerge, but pure beta exposure may remain risky until policy clarity improves and valuations reset.

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