USD rates have to consider the spectre of stagflation even as tariffs on Canada and Mexico have been delayed for a month as leaders from both countries took steps to assuage Trump’s concerns. For the US, inflation is probably a bigger concern than growth if tariffs rise, and the market has been trading as such. As inflation expectations rise in the immediate term, the Fed may well be constrained in easing. Meanwhile, moderation of growth optimism manifests as downward pressure on the long end of the UST curve. Some of this has been playing out as the 2Y/10Y segment of the curve flattened to 25bps on an intraday basis before rebounding. As written yesterday, tariffs against Canada and Mexico are likely just negotiation tools and should not be viewed as how Trump intends to wield tariffs to handle trade with the US more broadly. We suspect that a more systematic tariff policy would be mooted in March / April.
The impact of higher prices on the Fed is not straightforward. In our view, tariffs work as a one-off lift to prices and the Fed does have the option of looking through. Even if headline inflation does get a lift towards 3.5%, we don’t think the Fed would hike rates. Instead, growth concerns may start to weigh as the tariff war widen out. Between tariff uncertainties (which could weigh on investments) and production / imports frontloading (to avoid tariffs), the US / global economy may also cool off in the coming quarters. Should this play out, the Fed would be faced with a conflict of objectives and would likely place more weight on supporting growth, resteepening the curve in the process.
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