Update Bonds: Are we out of the woods now?
Last weekend, tariff talks between US and Chinese delegates in Geneva yielded a more positive outcome than expected, with both parties agreeing to temporarily eliminate post-Liberation Day tariffs and non-tariff measures, instituting a 10% universal tariff rate.
Starting 14 May, the US average tariff rate on China dropped to around 41%, while China's rate on US imports fell to about 28%. If maintained through 2025, these reductions could boost China's GDP by 1.5 percentage points, potentially decreasing the need for further fiscal stimulus.
This marks a significant shift in international trade relations, reducing uncertainties impacting fixed-income markets. Consequently, risk-on assets, such as equities and high-yield bonds rallied notably.
As tensions eased, yields on US and European government bonds rose, particularly short-term yields, as investors expect less need for central bank rate cuts. While a full recovery in US-China trade may not be immediate, imminent risks have diminished.
Tariff reductions might also lower inflation expectations uncertainty, although higher average tariffs still exert upward pressure on inflation. The implied lower recession probability suggests the economy may not cool as previously expected, increasing inflation pressures. This presents a challenge for the US Federal Reserve, where its last policymakers’ statement acknowledged the upward impact on inflation and unemployment from tariffs. It's uncertain which effect will be stronger or more immediate. We believe the inflation aspect will take precedence, likely resulting in no rate cuts in 2025. The market seems to align with this view.
The US also announced a trade agreement with the UK, mitigating credit risks. However, the US fiscal budget remains strained, leading to rising Treasury bond yields. Risk-on assets, including investment-grade and high-yield corporate bonds, saw strong rallies, with European bonds performing exceptionally well, due to reduced credit risk from lower average tariffs and prospects for new trade deals.
The agreement with the UK includes auto tariff reductions, potentially strengthening trade ties and enhancing market stability. For the eurozone, three key implications arise: softened global demand and supply shocks, reduced risk of Chinese goods flooding the EU market and the UK-US deal potentially serving as a model for future EU-US agreements, likely centred around a 10% baseline tariff.
This week's rally has returned most risky assets to pre-Liberation Day levels, suggesting minimal long-term impact. However, it's premature to assess how extreme uncertainty might affect economic data in the coming months. Long-term effects hinge on ongoing negotiations, with tariffs temporarily paused. Investing in this rally requires faith that recent turmoil was tactical and won't resurface.