Bond Experts Warn That the Fed Risks a Deflationary Spiral if It Doesn't Cut Rates

A prominent bond manager warns that the Federal Reserve’s decision to hold off on cutting interest rates could risk triggering a deflationary downturn known as a Kindleberger Spiral. This economic concept, named after renowned economist Charles Kindleberger, was first introduced in his influential 1973 book on the Great Depression and later updated in 2013 by economists Brad DeLong and Barry Eichengreen.

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The theory suggests that during periods of widespread “beggar-thy-neighbor” tariff policies, the central bank overseeing the world’s reserve currency must supply liquidity to offset the negative effects of reduced capital flows.

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Hoisington Investment Management Co. (HIMCO), an Austin, Texas-based bond investment firm well known for its quarterly letters analyzing macroeconomic trends, highlighted this risk in its second-quarter commentary. The firm emphasized that tariffs, particularly when retaliatory measures are introduced, lead to a decrease in both the demand and price of targeted goods. Over time, this can have far-reaching economic consequences.

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While HIMCO acknowledges that retaliation against tariffs has not been a significant issue outside of China in response to levies introduced during the Trump administration, they stress that international trade volume plays a crucial role in the global economy. Trade carries one of the highest multiplier effects on GDP, meaning that when trade activity declines, it dampens net foreign investment as well. This, in turn, reduces capital inflows into U.S. equities, government bonds, and other assets.

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This concern echoes views shared by other market commentators, who note that a shrinking trade deficit naturally limits foreign investment. HIMCO draws historical parallels to the 1920s and 1930s when the Bank of England, having suffered economic damage from World War I, could no longer act effectively as the global reserve currency. During that period, the U.S. Federal Reserve had the capacity to fill the liquidity void but failed to do so, exacerbating the economic downturn.

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Van R. Hoisington and Lacy Hunt, authors of the HIMCO letter, argue that the current Federal Reserve, under Chairman Jerome Powell, risks repeating history by remaining on the sidelines as global trade slows and capital flows contract. They point out that while other major central banks are lowering their interest rates to stimulate their economies, they do not manage the world’s reserve currency and therefore cannot sufficiently address the global liquidity shortfall.

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Despite these warnings about liquidity risks, HIMCO surprisingly supports the use of tariffs. The firm argues that tariffs, although economically disruptive in the short term, are a necessary tool to rebuild and diversify the U.S. industrial base. The vulnerabilities of relying heavily on foreign production became evident during the pandemic-induced supply chain disruptions and were further highlighted by Russia’s invasion of Ukraine. According to HIMCO, tariffs can help the U.S. move toward a more strategically balanced and efficient global allocation of resources.

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The firm also discussed the recently enacted One Big Beautiful Bill Act, noting that it helps prevent the risk of a “deep recession” that could have occurred if tax rates reverted to their 2016 levels. However, the act’s fiscal stimulus is relatively modest, estimated at around $30 billion annually, which may not be sufficient to counterbalance broader economic headwinds.

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Meanwhile, HIMCO’s own Wasatch-Hoisington U.S. Treasury Fund (WHOSX), which it manages as a subadvisor, has declined 4% so far this year. This underperformance reflects the broader challenges facing bond investors amid persistent inflation, restrictive monetary policy, and slowing global trade.

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In conclusion, HIMCO warns that the Federal Reserve’s current approach risks setting off a Kindleberger Spiral similar to conditions during the Great Depression. With tariffs dampening trade and capital flows and other central banks unable to compensate for liquidity shortfalls, the Fed’s inaction could deepen economic pressures.

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Nonetheless, HIMCO sees tariffs as a necessary long-term strategy to strengthen U.S. industry and resilience, even as they contribute to near-term deflationary risks and market volatility.

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