Bonds Show Fear Tariffs Will Deliver Inflation, Growth Shocks
(Bloomberg) -- The US bond market is flashing a warning to President Donald Trump that unleashing tariffs on top trading partners risks fueling inflation and slowing the nation’s economic growth.
His tariff decision — though subsequently delayed Monday in Mexico’s case — drove short-dated Treasury yields higher by as much as eight basis points to 4.28% on anticipation that it will keep interest rates elevated by pushing up consumer prices. But longer-term yields moved in the opposite direction on worries that the economy will stall, narrowing the gap between those on 2- and 30-year bonds by the most since early December.
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While the moves were pared after Trump agreed to temporarily postpone the increases on Mexico to allow for negotiations, the market’s broader direction largely held for the rest of the New York session, illustrating concerns that a trade war would deal fresh shocks to an otherwise resilient economy.
“It seems likely that the assumed direction of travel for now will be higher inflation and lower growth,” said James Athey, a portfolio manager at Marlborough Investment Management. “A flatter curve is the likely outcome along with a stronger US dollar.”
The risk that higher import prices could rekindle inflation has hovered over markets since Trump’s election in November, dashing any expectations that the Federal Reserve will cut interest rates much further this year. The central bank last month paused the monetary policy easing it started in September and futures are pricing in that it will remain on hold until July or September.
“Risks of stagflation are elevated,” said Jack McIntyre, portfolio manager at Brandywine Global Investment Management referring to the combination of stagnant growth and rising inflation. “Anything growth related needs to be looked at through the lens of uncertainty. Investment might get delayed until we get more clarity.”
Over the weekend, Trump followed through on his threat to impose levies on the exports of Canada, Mexico and China, while reiterating a warning to the European Union that tariffs “will definitely happen.” Goldman Sachs Group Inc. is positioning for the bond market’s current direction to continue, flattening the yield curve. Firms including BNP Paribas SA, Singapore’s DBS Bank Ltd. and Japan’s SMBC Nikko Securities Inc. said this puts the US economy at risk of falling into stagflation.
With gasoline and food not excluded from tariffs, BNP strategists said long-term inflation expectations could keep rising, favoring 10-year inflation-linked Treasuries.
Calvin Tse, head of Americas macro strategy and US economics at BNP in New York, said the Fed will likely keep rates on hold for the next couple of meetings while it judges whether growth or inflation risks are “more serious.”
“If this does indeed materialize, we think that rate hikes become a real possibility from the Fed this year, even in the face of lower growth,” they added.
While such a rate hike is currently seen as a long shot, the combination of inflation pressures and weakening economic growth also pulled down the stock market on Monday. The rush into havens is also benefitting long-dated bonds, which typically advance when the growth outlook sours.
“There is no chance the Fed can 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 the stocks continue to “drop a lot then flight to safety will mean an inverted yield curve.”
Euro-area bonds diverged sharply from US peers, rallying amid a broad flight to safety.
The Fed last week left policy unchanged as it waited for fresh progress on inflation. Data on Friday showed that the central bank’s preferred measure of underlying inflation remained muted in December and that real disposable income barely rose.
Goldman Sachs sees the Fed as more likely to hold rates steady to contain inflation risk than to cut them to boost growth.
“That more hawkish outcome ought to correspond to markets pricing more downside to growth/less upside to inflation further out, ultimately weighing on longer term yields and flattening the curve,” said Dominic Wilson, senior markets adviser at Goldman.
--With assistance from Matthew Thomas, Neha D'silva, Michael Mackenzie and Liz Capo McCormick.
(Updates prices throughout, adds comments in fourth paragraph)