Update Bonds - How trade tariffs impact yield curves
US President Donald Trump made good on his threat last weekend, announcing trade tariffs on all imports from Canada and Mexico. Both countries announced countermeasures almost immediately and thereupon Trump postponed the plans by a month. The imminent threat of a trade war is not only scaring stock markets. It also affects bond markets.
A direct consequence of potential trade tariffs is an increase in the cost of US imports. Higher import prices would make it even more challenging for the US central bank to combat inflation. Last week, the Federal Open Market Committee (FOMC) held its target for the federal funds rate steady after three consecutive rate cuts. Federal Reserve (Fed) Chairman Jerome Powell signalled that further rate cuts would be put on hold unless there is clear evidence of declining inflation or a weakening economy.
The Fed has already reduced rates by a full percentage point since it began its easing cycle in September. At the same time, yields on two-year US Treasuries have risen by more than 0.5 percentage points to approximately 4.20%. This elevated level in short-term yields reflects market concerns about the Fed's ability to lower rates in the face of persistent inflation. Markets are still anticipating two additional rate cuts this year.
Since mid-January, the ten-year treasury yield has been declining, hitting its lowest level of the year, this week. Higher import tariffs could slow US economic growth and potentially push the world's largest economy into stagflation. These growth concerns are exerting downward pressure on ten-year yields. As a result, the treasury yield curve is flattening, with the spread between two-year and ten-year yields narrowing to 25 basis points.
In the Eurozone, headline inflation inched up slightly in January, exceeding consensus expectations. Core inflation remained steady at 2.7%, still above the European Central Bank’s (ECB) target. Nevertheless, we do not expect the ECB to pause its rate-cutting cycle. European short-term yields are falling as markets price in further rate reductions. Although long-term yields are also affected by uncertainty over potential US tariffs, the European yield curve is steepening, driven by lower short-term yields.
Peter Bossaer