Bond markets have struggled to assess the impact of President Donald Trump's economic agenda on inflation, even as it forms a consensus on continued GDP growth, amid the ongoing uncertainty surrounding tax, tariff and immigration policies.
Benchmark 10-year Treasury note yields have risen by around 33 basis points, or a third of a percentage point, since Election Day on bets that Trump's tax and tariff policies would stoke already elevated inflation in the world's biggest economy.
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The 10-year yield, perhaps the world's most important financial-market metric and a proxy for risk-free interest rates, hit an October 2023 high of 4.8% earlier this month and was on its way to testing the highest levels since the global financial crisis, when a softer-than-expected tone on tariffs from Trump tamed Wall Street's bearish inflation forecasts.
Trump is now planning levies of around 25% on all goods imported from Canada and Mexico, both of which trade within a treaty he renegotiated in 2020.
He has also talked of an across-the-board tariff of 10% on goods from China, but told Fox News last night that he would "rather not" impose them, raising the prospects of a deal with President Xi Jinping.
Samuel Tombs, chief U.S. economist at Pantheon Macroeconomics, sees that framework having only a muted impact on the Federal Reserve's preferred inflation gauge, the core PCE Price Index, which he sees easing to 2.5% by year-end from its current level of 2.8%.
Trump tariff risks are hard to calculate
However, he adds a key caveat to that benign outlook, noting that "divining exactly which tariffs Trump eventually will implement is impossible."
"The president’s earlier threat of a 60% hike in tariffs on China, and of 20% on the rest of the world, seems like a plausible worst-case scenario that would likely lift core PCE inflation to a 3.5%-to-4% range later this year," he said. That level is "probably too high for the Fed to keep easing, but short of the 5.5% peak in 2022."
"We doubt, however, that such burdensome tariffs would be imposed perpetually, given likely public disapproval," he added.
Related: Bonds hold the keys to what's next for stocks
Morgan Stanley strategists, meanwhile, see inflation easing this year, a move the investment bank argues is likely to lead to lower Treasury yields and a weaker dollar, both of which could be a tailwind to U.S. stock performance.
"Our U.S. economists expect realized inflation to fall while most investors appear to be worried about inflation inflecting upward — a concern that market prices already reflect, according to our U.S. rates strategists," the bank said in a recent note.
"They suggest selling the U.S. dollar against the euro, the British pound and the Japanese yen."
BCA Research's chief strategist, Mark Papic, is also bearish on the dollar but sees the greenback's weakness manifesting more rapidly over the second half of the year.
"The government simply cannot continue powering U.S. assets through stimulative fiscal policies, and as soon as their spending realities crystallize, the dollar will weaken," he argues.
That echoes the factors that beyond inflation continue to affect U.S. Treasury yields as rising debt levels, alongside a ballooning budget deficit and pending fight over borrowing authority simmering on Capitol Hill, continue to test investors' patience.
Debt-ceiling debate redux
The Treasury is now operating under what it calls "extraordinary measures," where it moves money from various accounts and suspends certain nonessential payments. The move followed the expiration of a deal that suspended the U.S. debt ceiling of $31.4 trillion on Jan. 2.
Outgoing Treasury Secretary Janet Yellen estimated the measures could keep the government meeting its obligations, including the repayment of outstanding debts, until the middle of March.
Related: Goldman Sachs makes surprising pivot on interest rates
Scott Bessent, Trump's nominee for treasury secretary, told lawmakers last week that he would work with the president, who wants the ceiling abolished completely, although Bessent insisted that “the U.S. is not going to default on its debt if I’m confirmed."
But Republican lawmakers are looking to extend Trump's 2017 tax cuts, as well as his more recent campaign promises, in a one-bill strategy. The Committee for a Responsible Federal Budget estimates that bill could add another $7.5 trillion to the national debt.
A trillion here, a trillion there ...
Bank of America analysts, in fact, see U.S. debt rising to a record $40 trillion as early as next month, a level that would further complicate the optics of extending tax cuts without a corresponding change to spending commitments.
That's likely to weigh heavily on bond markets over the coming weeks, and even more so in March if a deal isn't struck and Treasury auctions are suspended following the exhaustion of the extraordinary measures Yellen detailed in her letter to Congress last week.
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"U.S. bond market investors have endured a lot lately, so the last thing they want to see is the government hold hostage the full faith and credit of the government’s willingness and ability to pay its debts," said Lawrence Gillum, chief fixed income strategist at LPL Financial.
"While its ability to repay its obligations is not in question, the debt ceiling debate complicates the country’s willingness to pay its debts," Gillum added.
"While we think Congress will act in time and either raise, suspend or even eliminate the debt ceiling, these games of political chicken can introduce volatility to markets in the meantime."
Related: Veteran fund manager issues dire S&P 500 warning for 2025
