The US bond market saw a significant rise in rates across the yield curve in the first half of April in the wake of the Trump administration’s tariff announcements. We now expect the US economy to pivot towards higher inflation and then slower growth. This ‘stagflationary’ trajectory may initially lead the Federal Reserve to take a cautious approach towards interest rate cuts before rising unemployment and a weakening economy trigger a continuation of cuts after the summer.
In an already tumultuous second quarter, the market´s focus is clearly on the rapidly changing import tariff news. That means market gyrations are likely to continue until agreement is reached, particularly between the US and China. Current tariffs have rendered commercial relations between the world’s two largest economies practically impossible and disrupted business.
The surprising large increase in tariffs announced by the Trump administration on ‘Liberation Day’ was reflected in market volatility. The MOVE index, measuring fixed income volatility, spiked to 140, while the VIX index (for equities) jumped to 52. Relative to history, these values are one to nearly four standard deviations above average (see Exhibit 1). It is little comfort that they are nonetheless lower than levels reached during the Global Financial Crisis or the Covid pandemic.
Trump’s ‘Liberation Day’ of tariffs kicked off a sharp bull steepening of the Treasury yields curve, declines in global equity markets and widening credit spreads. The initial risk-off purchases of longer-dated Treasuries eventually morphed into heavy selling pressure.
Ex-post explanations included:
- Selling of liquid securities such as Treasuries and gold by investors facing margin calls on equity positions, or looking to increase cash holdings
- Forced unwinds of futures basis trades and swap spread trades by hedge funds involving heavy selling of US Treasuries
- Unverifiable speculation of China selling of its US Treasury holdings and a poorly received 3-year auction that encouraged talk of reduced sponsorship from official institutions, especially China
- A speech by Fed chairman Jerome Powell: he said the Fed was in no hurry to adjust its policy stance and would be attentive to the inflationary consequences of tariffs, suggesting a reluctance to cut rates even amid slower growth
- Concerns over the weakening US dollar alongside equities and US Treasuries suggested that some investors may have been looking to diversify out of USD-denominated assets.
Recession talk – It’s not baseless
Because of the near-term disruptions to growth for both the US and China, we hope an agreement can be reached eventually. But as geopolitical considerations factor heavily in the minds of the countries’ leaders, one cannot know if or when this might happen.
The risk is that the longer it takes, the more market turmoil could eventually begin to damage the real economy. Predictions of a recession in the US or elsewhere are not unfounded.
An optimistic scenario would see tariffs lowered to a level which allows trade to resume, though this is not likely to apply to all products. There are numerous sectors where the Trump administration sees a strategic, national interest in protecting US domestic production. In that case, higher tariffs may be levied to make imports less competitive.
While the US economy has continued to grow thanks to a vibrant services (and high-tech manufacturing) sector, the administration believes it is not in the country’s long-term strategic interests to lack domestic production capacity in key areas. A fundamental change in the relationship between the US and the rest of the world is likely occurring.
Two scenarios for the US
Assuming the level of tariffs is revised down significantly and depending on the length of time this requires, we foresee two main scenarios for the US:
- A disinflationary slowdown
Raising tariffs implies fiscal tightening, higher prices and supply chain disruptions. Uncertainty over the direction of policy and higher costs will lead to lower investment and weaken consumption. We assume deficits don´t worsen as tariff revenues are used to extend existing tax cuts while spending is trimmed and new sources of revenues are found. In such an environment, rising prices would prevent immediate rate cuts by the Fed as it awaits confirmation that the impact is temporary. Rising unemployment would, however, allow the Fed to resume rate cuts later in 2025.
- Stagflation
Under this scenario, tariffs and immigration clampdowns would lead to goods and labour shortages and more persistent inflation. Reduced international competition would strengthen the pricing power of domestic companies. The administration would extend the existing tax cuts, increasing the deficit despite spending cuts. Potential growth would be reduced, but the economy would continue to run hot, meaning the Fed could not cut rates due to sticky inflation, but may even need to hike rates.
Portfolio changes
Under either scenario, the Fed would remain hesitant to deliver rate cuts in the immediate aftermath of a tariff-induced rise in consumer prices. However, the reality of falling growth and employment would force rapid cuts in the fed funds rate by late 2025 and into 2026.
Correspondingly, we added to our duration overweight (with a mix of TIPS and Treasuries) and reconfigured the portfolio towards a 7s/30s yield curve steepening bias.
The risk of an economic hard landing and risk-off backdrop – rather than a stagflation-lite scenario – prompted us to be more cautious on longer-dated breakeven inflation rates.
We retain these positions:
- We are overweight TIPS real yields and slightly overweight duration via 5-year Treasury futures
- We hold a position anticipating a steepening of the yield curve between the US Treasury 5- and 20-year maturities.
These positions should, in theory, do well when growth slows and tariffs raise prices, but second-round effects remain contained. This should allow the Fed to start an easing cycle in late 2025 or 2026.
The risk to this exposure is a sustained rise in US Treasuries yields driven either by a loss of investor confidence in US debt sustainability, selling by official institutions, or forced selling by leveraged investors.
