Since the infamous Liberation Day, where a stream of substantial reciprocal tariffs on various countries were announced and the world sunk in panic, there have been numerous developments in subsequent weeks — some suggesting a renewed level of optimism in the economy, and for others, not so much. In this article, we delve deeper into how the narrative has been gradually re-shaped after Trump’s initial threats of a global trade war.
90-Day Pause on Tariffs
Shortly after the announcement, Trump decided to instate a 90-day pause on reciprocal tariffs — with just a flat 10% duty being in effect for all imports. It seems that the pause came with intentions of fruitful negotiation between countries, and many of such discussions are under way as we speak. This does not come as a surprise, considering the ludicracy of the magnitude of reciprocal tariffs announced and the way they were calculated. Given that the imposed reciprocal tariffs have close to nothing to do with the actual effective tariff rates levied on the US, there is sufficient negotiating power on the table for most countries.
It is also crucial for the US to consider its own position as the world’s largest importer of goods — will there be sufficient domestic substitutes for imported goods? In a case where the US faces a drastic case of cost-push inflation due to a lack of import alternatives, how would the economy react? While the final outcome of the 90-day relief remains to be seen, investors remain optimistic about beneficial trade agreements which will reduce the chances of a full-blown trade war that will sink various economies into recession.
Peculiar Behaviour of Bond Yields
Typically upon the threat of a recession, bond yields will fall as investors flock to safer assets like treasuries to weather the economic storm, hence driving bond prices up and lowering their corresponding yields. Yet, after the stock market plunged upon the tariff announcements, bond yields in April spiked instead. This can be attributed to a multitude of factors.
Firstly, the market could be experiencing a VaR (Value-at-Risk) shock as a result of heightened economic uncertainty. Value-at-Risk measures how much money can be lost in a trade over a specific period, and it is inevitable that the market’s increased volatility has made trades significantly riskier. As a result, margin requirements for traders can rise significantly, causing them to sell assets for cash to keep on the sidelines. Treasuries, with their high liquidity, could be offloaded for this exact reason. A more specific case of VaR risk could exist within Treasury-based derivative trades, where investors or traders seek to profit off the difference in rates (or yields) when Treasury yields are benchmarked against other instruments — for example, European bond yields. You’d expect many of such traders to exit these trades during such periods of volatility, causing the supply of treasuries to rise, hence leading to a fall in prices and consequently, a rise in yields.
Secondly, the fears of cost-push inflation as a result of tariffs and a lack of substitutes cannot be understated. Tech companies like Apple (NASDAQ: AAPL ) make most of their hardware in key Asian production hubs like China, India and Vietnam. Fashion or clothing companies like Nike (NYSE: NKE ) manufacture over 90% of their brand footwear in Vietnam, Indonesia and China. The list goes on, and it is almost certain that the consumers will feel the sting of significantly higher prices if tariffs proceed on status quo. When inflation increases, fixed-rate bonds become less valuable as the present value of their future cash flows is eroded once adjusted for inflaton. As such, rising bond yields could be a result of increased inflation expectations which have affected bond prices to a large extent.
Lastly, while this cannot be confirmed, retaliation from other countries may be at play. Almost a third of US treasuries (excluding those held by the US government itself) are held by investors outside the US — currently worth about $8.5 trillion. Hostile actions against other countries, much like these reciprocal tariffs, could lead to retaliation in the form of reducing US treasury holdings — and we all know what the dumping of treasuries would do to the price of US treasury bonds and, as a consequence, bond yields.
All in all, the spike in bond yields suggest that the situation may not be as straightforward as it seems.
Tensions with China
One country that was not let off during the 90-day break was China. In fact, they were slapped with a 145% tariff — which China retaliated promptly with a 125% retaliatory tariff. The two giants have yet to ’work out their differences’, with each seemingly waiting for the other to relent. On the sidelines, investors are speculating on the winner of this tariff war. Some believe more strongly in China’s self-sufficiency, while others believe that China still very much needs the US as a trade partner. However, history has shown that at least in the short to medium term, there are no true winners in such an arrangement. Continued hostility in trade negotiations between the two could lead to unfavourable economic outcomes on both sides — potentially sending both economies into a recession. Trump is still waiting for what he calls a "fair deal" with China, which has been fruitless so far, at least at the time of writing this article.
Threatening the Fed’s Independence
It was not too long ago that Trump flirted with the idea of firing Federal Reserve chair Jerome Powell. He had also placed pressure on the Fed to lower interest rates by buying government bonds, which would push down yields and lead to more lending from banks, and more spending by households and businesses. However, while this eases the situation in the short term, it could lead to a more drastic case of inflation in the long-run as all that extra money works its way through the economy. Couple that with rising import prices due to tariffs and we could be in for an inflationary catastrophe.
Economics aside, a Fed that bends under political pressure does not exactly instil investor confidence in US assets. The independence of the central bank is what gives it its credibility. However, if we start to see cracks in this aspect, investors may also lose faith in US-denominated assets — potentially leading to capital flight and a weakening of the dollar.
All in all, it’s a tricky situation.
While there have been multiple developments since Liberation Day, it’s still tough to predict the outcome of this multi-layered situation. We will need to monitor the outcomes of various negotiations, and also observe how the whole trade feud with China can be resolved. In addition, we will keep our eyes on bond yields, stock market performance and subsequent decisions by the Federal Reserve to get clearer direction.
What can be said, however, is that the current position is likely a more optimistic one overall, mainly because the door is open for negotiations and fresh trade agreements. In addition, tariff exemptions on certain products are being rolled out as we speak — Trump just signed an order offering exemptions to certain car and parts tariffs. Ultimately, it is common knowledge that there are no true winners in a full-blown global trade war, and many believe that Trump, as unpredictable as he is, will eventually take action to prevent such an escalation. The idea of paying down national debt with tariff revenue, and simultaneously sending the economy to a recession to reduce interest payments on subsequently issued government debt through lower bond yields is one that may sound attractive in theory — yet in reality, there is a myriad of negative implications which may see the entire plan go south. Current market developments are already a clear foreshadowing of this.
