Policy Volatility and Market Implications
There’s an adage that there are decades when nothing happens and weeks when decades happen. The past several days have demonstrated that point.
The U.S. on 2 April unveiled the most significant tariffs in almost a century, deepening a rout in U.S. stocks. By 9 April, just as broad-based tariffs took effect, the U.S. 30-year bond yield surged amid a sell-off in the Treasury market. Later that day, President Donald Trump paused many of the tariffs for 90 days. Equity markets soared.
This was an unusually fluid week across financial markets as investors digested the prospect of tariffs along with questions around their implementation. Amid the volatility, it’s important to keep a longer-term perspective. Here are some of our latest observations about the economy and markets, as well as where we see investment opportunities.
Economy and inflation
- Tariffs rising. The pause creates time for negotiation, but the overall direction remains clear: Higher tariffs are likely here to stay (for more, read our 10 April publication, “President Trump Blinks for Now, But Tariffs Remain High”). The U.S. average effective tariff rate has been reset to levels not seen since the 1930s, and the implications are likely to be stagflationary domestically and contractionary globally.
- Inflation likely reaccelerating. The latest U.S. inflation data, released 10 April, showed softer-than-expected consumer price index (CPI) inflation that underscores weakness in the services sector before any material adjustments in goods prices occur. Looking ahead, we expect tariffs to cause inflation to reaccelerate – the question is by how much.
- Consumer sentiment sinking. The preliminary April University of Michigan survey, released Friday, showed near-record-low consumer sentiment combined with 40-year-high inflation expectations.
- Central banks diverging? In the U.S., if tariffs trigger a rise in prices just as a weakening economic outlook calls for lower interest rates, the Federal Reserve could be in a bind. (For more, read our 9 April publication, “The U.S. Economy’s Trajectory Amid Higher Tariffs.”) In contrast, other central banks may face fewer constraints when it comes to cutting rates.
Markets and opportunities
- Treasury auctions signaled orderly markets. Amid the price swings, strong investor participation at an auction of U.S. 30-year bonds on Thursday, and a similarly well-received sale of 10-year notes on Wednesday, indicated that Treasury market functioning remained stable and orderly, with demand still robust. Overnight funding markets also continued to function normally.
- Yields remained within their longer-term range. Although the speed of this week’s market moves has been unusual, overall yield levels don’t appear to signal deeper concern. Even after recent fluctuations, the U.S. 10-year yield is back where it was in February and remains within the general trading range over the past year and a half. This aligns with our expected cyclical range of 3.75%–4.75% (for more, see our latest Cyclical Outlook, “Seeking Stability”). We believe bond yields continue to look attractive and can offer a cushion in various economic scenarios, even if inflation persists above central bank target levels.
- The dollar declined even as U.S. yields rose. The U.S. dollar cheapened this week even as real U.S. yields climbed. Tariff policies, if they are successful in limiting trade flows, also limit foreign savings from entering the U.S., raising questions about the durability of U.S. capital markets exceptionalism.
- Opportunities to add global duration. We have been using this week’s market moves as an opportunity to add duration – a gauge of interest rate sensitivity – both in the U.S. and abroad, as yields have become more attractive. We have been gradually diversifying our interest rate exposure into other global fixed income markets beyond the U.S. We remain slightly overweight duration, favoring five- and seven-year maturities while remaining underweight the longer end of the yield curve.
- Monitoring credit risks and financial conditions. The prospect of a sharp deceleration in global trade flows and an elevated likelihood of recession increases the potential for a credit default cycle amid supply chain disruptions. As long as the ultimate destination for tariffs remains unclear, businesses are likely to delay investment. Combined with elevated interest rates, this could lead to tighter financial conditions.
- Focus on high quality assets. In today’s environment, we believe it makes sense to prioritize high quality, resilient investments.
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Disclosures
All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Equities may decline in value due to both real and perceived general market, economic and industry conditions.
Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.
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