Overview

In May, investors shifted their focus from worst-case scenario trade-war fears towards a more benign economic outlook supported by expansionary fiscal policy amid rapidly changing trade policy headlines. Market pricing discounted stronger economic growth, rising fiscal deficit funding needs, and tighter monetary policy than previously anticipated. Risk assets (Bitcoin, global equities led by US stocks) rallied, while both real and nominal bonds sold off globally and across duration curves. Meanwhile, oil sold off on news of OPEC supply increases despite a more benign economic outlook, rather than global growth fears. “Carry trades” (when traders borrow in a lower yielding currency to fund long trades in higher yielding currencies) were popular again, as traders were betting on lower currency volatility going forward.

The risk-on sentiment was supported by developments on the trade policy front – May kicked off with a pause in the Trump Administration’s exorbitant 145% tariffs on China and ended with the Court of Internation Trade (CIT) ruling against the Administration with respect to reciprocal and other tariffs imposed under the International Emergency Economic Powers Act (IEEPA) of 1977. The resurgence of risk appetite appears to be predicated on the assumption that we have seen the bottom in terms of aggressive tariff threats and trade policy uncertainty, at least at the macro level, and that tariffs from here may be more sectoral in nature. While sectoral tariffs will still create winners and losers, depending on implementation they may have a less-adverse macro impact. However, there are still meaningful trade-related risks on the table, as a number of trade negotiations appear to have stalled, at a time when investors have been increasingly focusing on fiscal challenges. Recent headlines on growing trade tensions between the US and China are a stark reminder of the significant challenges in reaching a broad agreement between the two countries. Considering the current level of risk-asset valuations and embedded expectations of firms’ earnings over the next few quarters, markets seem surprisingly sanguine despite continued high policy and macro uncertainty. Briefly on the key issues:

Outside of the US, most other economies are staring down disinflationary pressures, but policymakers may hesitate in providing needed monetary and fiscal easing. The rest of the world is set to face a sizable increase in excess capacity as global producers face weaker US import demand. In addition, many economies will also likely experience an increase in Chinese exports as some of the excess China production capacity will be diverted away from the US—a global disinflationary force. The growth impacts of this will vary, with manufacturing economies more exposed to growth slowdowns from lost US demand and increased competition from China. China itself continues to face significant economic challenges, as US policy choices are putting pressure on economies beyond the US (i.e., Europe) to put up their own protectionist trade barriers. Thats said, it remains very difficult at this stage of the tariff negotiations to conclude what the impact of trade tensions will be, and how spillovers will play out. What is certain is that heightened uncertainty will weigh on firms’ and households’ spending and investment decisions, with the impact from uncertainty growing the longer the tensions continue.

While the CIT’s ruling was a major blow to President Trump’s trade agenda, it does not necessarily mean the end of trade tensions. The Trump Administration has already appealed the CIT ruling and a federal appeals court has put the ruling on temporary, administrative hold; the Court is now considering whether to grant a more permanent stay while it rules on the substance of the challenge to the Administration’s tariff policies. In the case of an adverse ruling, the Administration is likely to take the case to the U.S. Supreme Court. Additionally, sectoral tariffs (steel, aluminum, autos) under section 232 of the Trade Expansion Act of 1962 remain in place, with more sectoral tariffs expected soon. More broadly, the Administration has a variety of other levers to replicate tariffs similar to those imposed under IEEPA (for example, as hinted by some Administration officials, by using Section 122 of the Trade Act of 1974, which allows universal tariffs up to 15% for a maximum of 150 days due to balance of payments deficits) – bottom line is trade policy uncertainty remains high, and in fact may actually rise further, though sequencing and overall impact remain unclear.

Between the remaining tariffs and very high uncertainty, stagflation risks are still on the table for the US.
Data on inflation and economic activity in April showed continued lower-than-expected price increases and better-than-expected economic resilience, but it’s too early to declare victory. The most recent ADP data, however, pointed to the lowest private-sector job creation in a couple of years. The full impact from tariffs will likely take several months to show up in the hard economic data, particularly as we know many US importers pulled forward demand and built inventories earlier in the year in anticipation of changing trade policy.

Against that backdrop, high US government debt levels and wide fiscal deficits present an additional risk and vulnerability. This is true for many economies globally, but the US has been an increasing focus of concern given the sheer scale of the deficit in dollar terms and significant reliance on foreign investors.The Fed is continuing with its quantitative tightening (QT) program, leaving price-sensitive investors as the marginal buyers, at a time when investors may be inclined to reevaluate their US dollar exposure given already high US holdings and continued geopolitical turmoil. With the current tax bill working its way through Congress in the US and discussions for additional fiscal stimulus in many other global economies (i.e., Europe increasing defense spending, Japan’s current stimulus bill), investors in global government bond markets may require additional compensation to bear duration risk—as evidenced by rising long-term yields alongside a weaker dollar (an inversion of the typical relationship), suggesting that foreign investors are requiring a higher risk premium in order to be incentivized to hold US government debt.

Below, we show a series of charts illustrating these themes playing out in recent market action and pricing, before providing additional perspectives on the key issues mentioned above. The line marks the start of May.

Markets shifting focus away from worst case trade war fears, resulting in a May equity rally and the dollar more or less flat over the month….

…but bonds continued to sell off and term premiums continued to rise on expectations of greater fiscal funding needs and tighter central bank policies.

Bloomberg

This next set of charts provides a 20-year perspective of the same financial market developments. While markets have been volatile year-to-date, and the speed of the repricing in bond yields and the dollar have been notable, the moves are still relatively contained when viewed from an historical standpoint. Bond yields are within the range that has prevailed over the last three years (with the exception of Japanese bond yields, which lagged behind the rise in other developed world yields seen in 2022);  term premiums are moving up rapidly toward more or less “normal” levels witnessed prior to the Great Financial Crisis;  and the dollar is still trading at a secular strong level despite the weakness; this year equities are still near highs following years of strong performance (particularly US equities).

Two other perspectives below on the expectations reflected in market pricing. Equity market valuations (the price investors are willing to pay relative to near-term earnings are still elevated compared to history, reflecting a combination of compressed equity risk premia (a measure of investor required compensation to bear equity risk) and stronger than historical future earnings growth expectations. While most equity market valuations look relatively sanguine, US equity market valuations look especially optimistic – as shown below, this is in part true for the aggregate market due to elevated valuations for the “Magnificent 7” technology stocks, where strong earnings growth prospects from winner-takes-all dynamics related to AI technology capture may justify such strong valuations. But even outside of the Magnificent 7, US equities are trading at elevated valuations compared to history. As shown on the right below, credit market pricing also reflects strong risk appetite.  After a brief spike following Liberation Day, credit spreads have retraced and are now very compressed, reflecting a mix of relatively sanguine expectations for credit default risks and compressed credit risk premia (analogous to the equity risk premia).

Bloomberg

The optimistic pricing in risk assets may partially be a reflection of the market’s expectation that global central banks will provide accommodation by lowering rates and easing monetary policy. As shown below, aside from the Bank of Japan, most central banks are priced to cut their policy rates in the next twelve months. However, it is worth noting that easing expectations have been reduced in the last two months, especially in May, as trade war fears were alleviated somewhat and expectations for stronger fiscal stimulus were priced in.

Bloomberg

Finally on market pricing, the two charts below reflect the shift in the behavior of the US dollar compared to the past – in recent years, when US real yields have risen, the US dollar has also strengthened, relative to both developed world currencies and emerging market currencies. This relationship typically occurs both because rising US real yields have been a reflection of US economic strength, attracting investors into US assets, and because rising real yields squeeze dollar liquidity and dollar borrowers.

That relationship has now shifted – even as US yields are rising, the US dollar is selling off as term premia on US government debt are rising, suggesting that foreign investors no longer see the US higher yield as attractive in relative terms and thus requiring a higher risk premium in order to be incentivized to hold US government debt.

For many investors and for policymakers, one of the key issues to watch going forward will be a continuation or acceleration of this dynamic – with foreign investors potentially looking to reduce their high exposure to US assets, especially in light of elevated geopolitical tensions and the possibility that today’s trade war could spill over into a capital war. Notably, Section 899 of the “One Big Beautiful Bill Act currently before the Senate includes a clause that gives the Treasury secretary the power to levy retaliatory taxes on the US investments of foreign countries that have levied “unfair taxes” on US companies. While some aspects are still unclear and the bill could be modified, market participants have highlighted the risk that foreign investors, US companies with foreign ownership, and international firms with US branches could be meaningfully affected, providing an incentive to sharply reprice US dollar assets if not meaningfully reduce their (already high) exposures.

Bloomberg

Trade Policy Shifts and Uncertainty

Market pricing over the last month has reflected lower odds of a tail risk to the global economy from the trade war. Nonetheless, any cheering should be taken with a grain of salt given continued elevated uncertainty. While a court ruling on the IEEPA tariffs (which stated President Trump had overstepped his authority) was a clear setback for the Administration, there are still meaningful tariffs on the table and the Administration has other tools for authorizing further tariffs that could ultimately achieve a similar tariff outcome as sought under IEEPA. The table below shows the status of the US tariffs as of June 4^th. The Court of Appeals for the Federal Circuit granted a temporary stay on the IEEPA tariffs ruling by the CIT, while it hears the Administration’s appeal (keeping the tariffs in place for now.

Council on Foreign Relations

Regardless of the ultimate ruling of the Court of Appeals on the IEEPA tariff authority (and possibly the US Supreme Court), the Administration has a variety of other levers that could be utilized to impose tariffs. Given President Trump’s clear intent to raise the average U.S. tariff in order to reduce bilateral trade deficits, raise revenues to finance tax cuts, and incentivize a manufacturing renaissance in the US, uncertainty remains high and the trade war is unlikely to be over.

Goldman

Implications for the U.S. Economy and Fiscal Funding Strains

For the US economy, even without the IEEPA tariffs (but especially in the event the Administration employs other trade policy tools to replicate the same IEEPA tariff outcome), the impacts will likely be stagflationary, driving up prices (at a time when inflation is already running above the Fed’s 2% inflation target) and reducing real economic activity. The question is to what extent. As shown below, even without the IEEPA tariffs, the average US effective tariff rate is already higher than it has been in decades. We have already seen prices paid by US producers spike up in April and May, and based on a recent survey from the Federal Reserve Bank of New York there is mounting evidence that most businesses are passing on these rising costs to consumers at a relatively rapid rate.

Yale Budget Labs (Tariff Rate Estimates), Bloomberg, Federal Reserve Bank of New York

Beyond any one-off boost to prices from tariffs, there are various channels through which tariffs could spill into a more sustained rise in inflation. A de-anchoring of longer-term inflation expectations is a crucial risk, which Chair Powell cited in his remarks on earlier this month: “The effects on inflation could be short-lived, reflecting a one-time shift in price level. It is also possible that the inflationary effects could instead be more persistent…Near-term measures of inflation expectations have moved up, as reflected in both market and survey-based measures… Beyond the next year or so, however, most measures of longer-term expectations remain consistent with our 2% inflation goal.”  We show the University of Michigan’s consumer inflation expectations survey below – while recently criticized for being driven by partisanship, it’s nonetheless worrying that both short-term and longer-term inflation expectations have been on the rise.

An additional channel is via supply chain disruptions and goods shortages. It may take a few months to understand how the tariffs have disrupted goods shipping and to quantify  any potential materializing shortages (including those due to rare earth metal embargoes, where China is the dominant refiner). As shown below, container shipping prices have recently been volatile and rising – reflecting fast moving shifts in trade as importers alternatively rush to move goods into the US ahead of tariffs (with today’s current pause on 145% tariffs on China driving a surge in front-loading and shipping prices) or at other times cancel shipments as tariffs change the economics of imported goods. This volatility may add to any shortages and price increases via resulting backups at ports and surging transportation costs during front-loading periods. And for the Federal Reserve, the shifts in shipping and inventory building will add to the challenges in interpreting new US economic data.

Bloomberg

So what about the tariffs’ impact on economic activity? Tariffs will weigh on economic activity if consumers pull back on spending due to uncertainty or weaker real incomes as prices rise. Businesses also may delay capital spending plans or hiring if they are uncertain about prospects given rapidly shifting trade policies. So far, a wide variety of surveys show a negative hit to sentiment, but hard economic data have shown resilience. However, the impacts of the tariffs may take time to materialize, and we likely won’t see the full impacts in hard economic data until later this summer.

One segment that does look to be materially impacted is IPO and M&A activity. After showing some signs of recovery in 2023 and 2024, recent data show a rapid retracement to depressed levels, as uncertainty weights on potential dealmaking. As another reflection of weakness in this area, equity prices of PE firms such as KKR and Apollo have materially underperformed the overall US equity market recently. While a relatively narrow subsection of economic activity, we highlight the weakness in financial engineering and dealmaking as an example of how uncertainty due to shifting trade policies is likely to weigh on business planning and investment going forward.

Bloomberg

As of now, with inflation above target and additional pressures on prices coming from tariffs, the Federal Reserve has adopted a “wait and see” attitude” as it seeks confirmation about the impact of tariffs on both sides of its mandate—inflation and employment. Most recent data point to some weakness in activity: on Wednesday, June 4^th, the ISM’s services industry index dropped into contraction territory, and a separate report from ADP showed private-sector payrolls rose the least in the last two years.

That said, hard economic data continue to show  resilience. Unemployment remains low, job openings relative to unemployment point to relatively plentiful jobs , and job growth through April has been  healthy (note – May payrolls data will be released the day after the publications of  this report). As noted, however, it may take several months for the impact of tariffs to materialize. In the event of a more significant economic slowdown, the Federal Reserve may face an unpleasant trade off, especially if an economic slowdown is accompanied by a sustained rise in inflation.

Bloomberg

The current trade tensions  and accompanying economic risks are taking place against a backdrop of persistently high government debt and fiscal deficits, which are likely to be exacerbated by the “One Big Beautiful Bill” currently working its way through the US Congress (CBO estimates that the bill would increase deficits by $2.4 trillion over the next decade). While yields are still within the range seen over the last couple of years, there are significant risks that lack of demand in the face of a significant supply increase will result in a further rise in longer-term yields going forward. This is true for many economies globally, but the US is especially vulnerable given the sheer scale of the deficit (as shown on the first chart below, notable for a period outside of recessions) and significant reliance on external funding from foreign investors.

The scatter chart below highlights the US large  negative net international investment position (i.e., a reflection of the US’s reliance on foreign investment flows). It is important to note that a key reason for foreign capital flowing into US debt markets has been the strength of the US economy relative to other developed economies over the last decade—a development supporting higher US yields relative to other countries. As a result, foreign investors could earn greater returns holding US debt, in many cases even after hedging currency risks. Now, with higher yields across many global economies, yields on US government debt may be less appealing on a relative basis (especially if FX hedged) –the cost to hedge currency risk for these foreign investors has risen as US short-term rates have remained high.

Bloomberg

These forces are playing out at a time when the Federal Reserve and other central banks are continuing to shrink the size of their balance sheets via quantitative tightening (QT), leaving price-sensitive investors as the marginal buyers.

IMF Financial Stability Report (October 2024)

In case of a significant economic slowdown that would require an extremely low policy rate for a long time, the Federal Reserve could theoretically engineer lower longer-term nominal yields via asset purchases, helping push down private sector nominal borrowing rates.  But taking this policy course (which would implicitly amount to financing fiscal issuance via money printing) would risk reigniting inflation and unmoor inflation expectations. Since Covid, the US has managed to lower inflation toward the 2% target despite very high public sector borrowing precisely because private sector credit has remained depressed due to high borrowing costs. Against a backdrop of continued strong fiscal impulse and large fiscal deficits, it appears unlikely the Federal Reserve will be in a position to engineer a hand-off from the public sector to the private sector.

USA Financial Accounts, Bloomberg

Looking Around the Globe – Facing Down Disinflation Pressures

Outside of the US, the rest of the world is staring down weaker growth and disinflationary pressures. The US is the world’s largest consumer of excess production capacity. As shown on the first chart below, the US has been running for decades a current account deficit , while the rest of the world in aggregate has been running a current account surplus. The tariffs the US is imposing will result in lower demand in the rest of the world, and production will as a result be curbed in aggregate (the degree to which different economies will see falling demand will vary depending on country-specific circumstances). “Production economies” such as China, Korea, Japan, and Germany are more exposed than economies such as Australia (where the most significant exports are commodities) – barring a significant slowdown of the global economy resulting in a sharp drop in commodity demand.

IMF World Economic Outlook (April 2025), World Bank Development Indicators

Beyond just facing weaker US demand, a number of economies will also be exposed to redirected goods from China. China has built significant excess production capacity in recent years (see the first chart below), outstripping weak domestic consumption. With the US taking measures to sharply curtail goods supply from China, that excess production will likely be directed elsewhere. Many other economies (beyond the US) may take measures to prevent such dynamics. For example, Europe, where competitiveness challenges from Chinese goods have already caused significant pain (see depressed German industrial production below), may take measures to limit Chinese imports. The EU has already implemented tariffs on Chinese electric vehicles last year in response to overcapacity in that sector, and it has recently set up a task force to monitor the risk of rerouting Chinese imports toward the US.

“Alongside the European Commission and in full unity, our goal is clear: to negotiate the removal of these unfair tariffs and reach a balanced agreement without asymmetry. We must remain strong. Europe must keep working on all necessary countermeasures and mobilize every available tool to protect itself, including against redirected flows from third countries that risk destabilizing our market. – French president Emmanuel Macron via X

IMF Global Economic Outlook, Bloomberg

Appendix

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