After being downgraded, the United States faces a choice: either reduce tax cuts or increase tariffs?

Moody's downgrade of U.S. credit sounds the alarm, as the U.S. faces a dilemma of either reducing tax cuts or increasing tariffs.

According to Wind Trading Desk, Bank of America stated in its latest report that market concerns about U.S. Treasury bonds have persisted for some time, and the timing of Moody's downgrade is not coincidental, aiming to remind the U.S. government that tariff revenues will not fully offset the proposed tax cut costs.

Nevertheless, Bank of America indicated that the U.S. may insist on proceeding:

From our perspective, the more likely scenario is that we will still obtain an expansionary tax plan, and long-term U.S. Treasury yields should continue to reflect concerns about the fiscal outlook.

The risk is that when Washington takes U.S. fiscal issues seriously, tariffs may be the only effective means to reduce the deficit, and another round of large-scale tariff increases could cause greater harm to the economy than a less expansionary fiscal plan.

The Timing of the Downgrade is Not Coincidental

Bank of America stated:

Recently, many clients have inquired whether the bond market is approaching a critical point where investors' concerns about debt sustainability will erupt. After Moody's downgraded the U.S. rating from Aaa to Aa1 on Friday evening, this question became particularly prominent.

From our perspective, the timing of this downgrade is not coincidental. With tax cuts and tariff policies in limbo, Moody's seems to be conveying a message: it believes these policy changes will further deteriorate the U.S. fiscal trajectory. Specifically, tariff revenues will not fully offset the costs of the proposed tax legislation. We agree with this.

Since this is not a new issue, market reactions have been relatively mild so far. Bank of America strategists expect that the downgrade will not lead to U.S. Treasuries being excluded from any major fixed-income indices, thus not triggering passive selling of U.S. government bonds. However, due to the continued deterioration of fiscal conditions, they hold a negative outlook on long-term U.S. Treasuries.

More Responsible Fiscal Measures or Expansionary Tax Policies + Tariffs

The current question is whether this downgrade will prompt Congressional Republicans to shift towards more fiscally responsible proposals, including reducing or delaying the scale of tax cuts and/or increasing spending cuts. This would be detrimental to short-term growth but beneficial for the long-term fiscal health of the U.S. The volatility in the bond market will increase the likelihood of this outcome.

Bank of America stated:

But from our perspective, the more likely scenario is that we will still obtain an expansionary tax plan. Long-term U.S. Treasury yields should continue to reflect concerns about the fiscal outlook.

However, unless there is a sudden change, the risk is that when Washington takes U.S. fiscal issues seriously, tariffs may be the only effective means to reduce the deficit. Another round of large-scale tariff increases could cause greater harm to the economy than a less expansionary fiscal plan