US Bond Market Signals Inflation and Growth Risks from Trump Tariffs
The US bond market is conveying a warning to President Donald Trump that implementing tariffs against significant trading partners poses risks of fueling inflation and decelerating economic growth.
Trump's tariff announcement, although subsequently delayed for Mexico, initially sent short-term Treasury yields higher by up to 8 basis points to 4.28%, fueled by expectations of elevated interest rates due to potential consumer price increases.
However, longer-term yields moved inversely, reflecting concerns about economic stagnation, resulting in a narrower spread between 2- and 30-year bond yields, the most significant decline since early December.
Despite a partial reversal after Trump's agreement to temporarily postpone Mexico tariffs for negotiations, the market's broader trend persisted throughout the New York trading session, highlighting worries that a trade war could shock an otherwise robust economy.
"The path ahead appears to be higher inflation and slower growth," said James Athey, Portfolio Manager at Marlborough Investment Management. "A flatter yield curve is likely, along with a stronger US dollar."
The possibility of increased import costs reigniting inflation has loomed over markets since Trump's election in November, quashing expectations for significant interest rate cuts by the Federal Reserve this year. The central bank paused its monetary policy easing initiated in September, and futures markets anticipate a hold until July or September.
"Stagflation risks are elevated," said Jack McIntyre, Portfolio Manager at Brandywine Global Investment Management, referring to the combination of sluggish growth and rising inflation. "Any growth-related investments should be assessed with uncertainty. Investments may be delayed until we gain more clarity."
Over the weekend, Trump imposed tariffs on exports from Canada, Mexico, and China and reiterated his threat to the European Union.
Goldman Sachs Group Inc. anticipates the bond market's current trend to continue, flattening the yield curve. Other firms, including BNP Paribas SA, DBS Bank Ltd., and SMBC Nikko Securities Inc., warn that this places the US economy at risk of falling into stagflation.
BNP strategists suggest that as long-term inflation expectations could continue to rise due to tariffs on gasoline and food, 10-year inflation-linked Treasuries may benefit. Calvin Tse, BNP's Head of Americas Macro Strategy and US Economics, believes the Fed will likely maintain interest rates at current levels for the next few meetings while assessing which risk is more significant: growth or inflation.
"If this [stagflation] materializes, we expect rate hikes to become a real possibility for the Fed this year, even with lower growth projections," they added.
While such a rate hike is currently considered a remote possibility, the combination of inflation pressures and weakening economic growth also contributed to a decline in the stock market on Monday. The rush to safe havens is also benefiting long-term bonds, which typically perform well when the growth outlook deteriorates.
"The Fed is highly unlikely to cut rates for the foreseeable future," said Kathy Jones, Chief Fixed Income Strategist at Charles Schwab. "The market is pricing in higher inflation," and if stocks continue to "drop significantly, flight to safety will lead to an inverted yield curve."
Euro-area bonds diverged significantly from their US counterparts, rallying amidst a broad flight to safety. Last week, the Fed maintained policy unchanged, awaiting further progress on inflation. However, data released on Friday showed that the central bank's preferred measure of underlying inflation remained muted in December, while real disposable income barely increased.
Goldman Sachs expects the Fed to prioritize holding rates steady to contain inflation risks rather than cutting them to stimulate growth. "This more hawkish stance should correspond to markets pricing in greater downside risks to growth and less upside to inflation in the future, ultimately weighing on longer-term bond yields and flattening the curve," said Dominic Wilson, Goldman's Senior Markets Advisor.