Bond markets are waking up to Trump's chaotic tariffs regime

Telegraph

2 days ago

If you didn't already fully understand the meaning of 'uncertainty', last week should have provided you with plenty of learning material.
The concept of uncertainty relates to a situation when there is no known calculus for anticipating future outcomes. This contrasts with the concept of risk – when you can gauge the probabilities. Perhaps the purest case of risk concerns the chance of a ball sent spinning by a roulette wheel landing on a particular number.
One hundred years ago, John Maynard Keynes made much of this distinction but it is still given insufficient attention. Financial and economic analysis is usually conducted solely on the basis of risk. The world is full of people who seem to think that they can calculate risks when, in reality, they haven't a clue.
Keynes thought that the financial and business worlds were beset with endemic uncertainty. Sometimes economic agents would be immobilised by it. At other times, they might simply put it out of their mind, or assume the best, or press on regardless. This is why he thought market participants' 'animal spirits' were so important.
In general, financial markets hate uncertainty and so do the managers of financial and non-financial businesses. Last week, the uncertainty quotient leapt up thanks to the still developing consequences of Donald Trump's trade policies.
The fun and games last week started when the US Court of International Trade (CIT) blocked two of Trump's key tariff measures, that is to say, 'trafficking tariffs' – i.e. those related to fentanyl on Canada, Mexico and China – as well as his 'worldwide and retaliatory tariffs' on most countries.
It took this action because it believes that the US president didn't have the authority to impose these tariffs under the International Emergency Economic Powers Act.
You might imagine that this would have an extremely favourable impact, as it seemed to imply a yet further unravelling of Trump's tariff shock. After all, the markets were badly hit when Trump first announced his tariffs on 'liberation day'. So you might reasonably think that markets would surge on news of their undoing. Indeed, the US and other equity markets did react favourably at first.
But then the euphoria fizzled out. Partly, this was because equity markets had already regained most, if not all, of the ground they had lost on the initial tariff announcements – due mainly to Trump's backtracking and apparent second thoughts.
The lukewarm reaction was also partly because it is widely assumed that the Trump administration would find a way round this. Indeed, on Thursday a US appeals court granted at least a temporary reprieve. The next stop will be the Supreme Court, which is dominated by Republicans.
Moreover, even if the Supreme Court upholds the CIT's ruling, the Trump administration would probably try to find other ways of increasing tariffs, such as ramping up Section 301 and 232 investigations into various countries' trade policies, or trying to get Congress to pass legislation imposing tariffs.
It was striking that the CIT's ruling wasn't warmly welcomed by the US Treasury market. Indeed, the 10-year bond yield initially edged up to over 4.5pc.
The dominant thinking here concerns the possible fiscal implications of a failure by the Trump administration to enact widespread tariff increases.
This is because the extra tariff revenue to be raised by Trump's measures was intended to largely offset the loss of tax revenue resulting from Trump's 'big beautiful bill', introducing or extending substantial tax reductions, which has now passed the House of Representatives. If the president presses on with tax cuts but is unable to push through substantial increases in tariffs then the implication would be a significant increase in the budget deficit – hence higher bond yields.
Admittedly, if Trump's tariffs are blocked, then there would be much less upward pressure on inflation and that would make it easier for the Federal Reserve to cut interest rates sooner and by more than would otherwise have been the case. Ordinarily, the bond market would like this.
But if Trump is prevented from using tariffs as a way of closing the American trade deficit, then he may well want to substitute policies that would cause the dollar to fall substantially. That would renew inflation worries at the Fed – as well as causing widespread consternation among international holders of dollar assets.
Actually, a depreciation of the currency, rather than tariffs, is the textbook way of addressing a trade deficit. But, of course, currency depreciation doesn't discriminate between countries and it affects both imports and exports of all types of goods, as well as services. That is precisely why economists tend to favour it.
Importantly, though, unlike the imposition of tariffs, a currency depreciation does not produce any extra revenue for the government. That is the key reason why the Trump administration has favoured tariffs.
As well as the potential impact on US financial markets and the American economy, these tariff shenanigans potentially have major effects on the world economy. If the proposed tariffs are rescinded, the countries set to gain the most are those heavily exposed to trade with the US – Canada, Mexico, Vietnam, Korea and Japan.
Importantly, with tariffs on automative, steel and aluminium imports still in place, Canada, Mexico, Japan and Korea are heavily at risk – unless they can negotiate further concessions as the UK did.
lose patience with Vladimir Putin. He may well impose tougher sanctions on Russia and those countries dealing with it, or even step up military aid for Ukraine.