It's not just tariffs; another major event is underway that will impact global markets in the coming months

While the global market is still digesting the large-scale tariff policy of the United States, the Trump administration has quietly advanced another fiscal action that will significantly impact the global financial market in the coming months.

In the early hours of Saturday, the U.S. Senate passed a bill called "budget reconciliation" with a narrow margin of 51-48 after an all-night "marathon" voting session.

The strategic significance of this budget resolution lies in unlocking the "budget reconciliation" mechanism, which will allow Republicans to bypass the Senate's filibuster rules. Through this procedure, Republicans can pass Trump's tax, border security, and military priority bills with a simple majority without Democratic support.

The passage of this budget resolution marks a key step in the Trump administration's tax reduction agenda, but there are still significant differences between the two chambers of Congress, particularly regarding how to fund the tax cuts and the depth of spending cuts. Additionally, the Senate plans to raise the U.S. debt ceiling by $5 trillion.

Analysis indicates that the scale of tax cuts and the uncertainty of debt financing will determine the direction of the bond market, with differences in U.S. Treasury yields potentially reaching 60 basis points under different scenarios. Furthermore, once the debt ceiling is raised, the scale of U.S. Treasury basis trading may trigger market liquidity risks.

At the same time, this will increase the likelihood that the U.S. will have to adopt more unconventional policy measures in the future, including the previously discussed "Mar-a-Lago Agreement."

Huge Scale of Tax Cuts and Increase in Debt Ceiling

The budget reconciliation bill passed by the Senate includes a tax cut plan of up to $5 trillion, which extends the Trump tax reform policy from 2017 (originally set to expire at the end of this year) and adds an additional $1.5 trillion in new tax cuts.

Meanwhile, the Senate version of the plan also raises the U.S. debt ceiling by $5 trillion. If the debt ceiling is not raised, the Congressional Budget Office predicts that the U.S. may breach the debt ceiling in August or September of this year, which would prevent the U.S. government from issuing new debt and paying various bills, including those to bondholders.

However, there are significant differences between the House and Senate versions on key details:

The House only sets a tax cut scale of $4.5 trillion.

The Senate plans to cut about $4 billion in spending, while the House seeks to cut at least $1.5 trillion in spending.

The House version includes a directive for the Energy and Commerce Committee to cut $880 billion in spending, raising concerns that it could severely impact the Medicaid program.

The Scale of Tax Cuts and Uncertainty of Debt Financing Will Determine the Direction of the Bond Market

Peter Sidorov, a senior economist at Deutsche Bank, pointed out in a recent study that the announced tariff measures already constitute the largest tax increase in the U.S. in 50 years (as a percentage of GDP). However, even with annual tariff revenues of $300 billion to $500 billion, it can only cover about one-fifth of the U.S. federal budget deficit in 2024 (close to 7% of GDP, approximately $2 trillion) Deutsche Bank emphasized that the existence of fiscal offset measures to mitigate the impact of tariffs will have different effects on the market. They pointed out that the potential scenario differences in U.S. 10-year Treasury yields under tariffs could reach 60 basis points (0.6%).

The degree of looseness in future fiscal decisions will directly affect the upward space of the U.S. term premium: if the tax cuts are too large without corresponding spending cuts, U.S. Treasury financing will face severe challenges and may push up long-term interest rates. At the same time, this will also increase the likelihood that the U.S. will have to adopt more unconventional policy measures in the future, including the "Mar-a-Lago Agreement" that some investors are concerned about.

The scale of U.S. Treasury basis trading may trigger market liquidity risks

More concerning is that, from a technical perspective, since the Federal Reserve began to shrink its balance sheet in 2022, U.S. hedge funds (especially multi-strategy platform funds) have become the largest marginal buyers of U.S. Treasuries. They are not bullish on U.S. Treasuries but are engaged in basis arbitrage trading: going long on U.S. Treasury cash bonds while shorting U.S. Treasury futures to profit from the term price difference.

These hedge funds often leverage in the repurchase market to buy U.S. Treasury cash bonds to enhance returns. It is estimated that the scale of this trading may have reached nearly twice the historical high point in the second half of 2019, and the trigger for the global financial market turmoil in March 2020 was the unexpected liquidation of the historically high scale basis arbitrage trading at that time.

Once the debt ceiling issue is resolved, the U.S. Treasury will issue a large amount of U.S. Treasuries that were previously unable to be issued due to the debt ceiling restrictions. If there is no debt restructuring, the surge in bond supply may trigger an increase in market volatility, triggering the aforementioned arbitrage trading liquidation, thereby leading to the risk of a "triple kill" in U.S. stocks, bonds, and currencies.

Is the Mar-a-Lago Agreement becoming a reality?

Against the backdrop of massive tax cuts and the tariff war disrupting global trade, the U.S. government may need to take further unconventional measures to manage the surging debt.

As mentioned in a previous article by Wall Street Insight “Global Capital Flow Changes: From 'Biden's Big Cycle' to 'Trump's Big Reset'”, if the debt issue worsens, the so-called "Mar-a-Lago Agreement" may move from theory to practice. This agreement may include converting some U.S. Treasuries into long-term zero-coupon bonds or even some form of restructuring of Treasury bonds.

At the same time, the Federal Reserve may be forced to reconsider unconventional monetary policy tools such as quantitative easing (QE) or yield curve control (YCC) to cope with debt pressure and market volatility