US bond traders have adjusted their pricing to account for an anticipated surge in inflation resulting from Donald Trump’s tariff policies, which is creating additional pressure on the Federal Reserve as it attempts to lower interest rates to bolster an economy impacted by these trade measures.
On Thursday, global markets experienced declines as investors sought safety in more secure assets. This reaction followed Trump’s unexpectedly stringent tariff plans, which included a base duty of 10%, with potential significant increases for trade partners like the EU and China.
The market’s expectations for short-term inflation have intensified, as indicated by a sharp rise in one-year inflation swaps—derivatives reflecting market views on inflation—which approached 3.5% on Thursday, the highest since 2022.
This increase highlights the complex challenge faced by Federal Reserve Chair Jay Powell in balancing the likelihood of rising prices against weakening GDP growth. Krishna Guha, vice-chair at Evercore ISI, noted that the heightened risks to inflation and employment further complicate the Federal Reserve’s position, as officials worry that substantial tariffs could affect underlying inflation and destabilize inflation expectations.
Having been previously affected by inflation following the lifting of Covid-19 lockdowns, the central bank is eager to demonstrate a commitment to controlling inflation, even while addressing a weakening US consumer base. Recently, growth prospects have diminished due to concerns over rising import prices and declining corporate confidence, raising fears of a potential recession.
In response, markets anticipate more aggressive rate reductions by the Fed, with investors now expecting four quarter-point rate cuts by year’s end, compared to the three anticipated prior to Trump’s tariff announcement. At the same time, expectations for consumer inflation have risen, adding complexity to the Fed’s objective of supporting the economy through reduced borrowing costs.
Jay Barry, a strategist at JPMorgan, warned that the tariff announcement suggests a potentially larger near-term increase in inflation and a more significant negative impact on growth than anticipated by the markets. Austan Goolsbee, president of the Chicago Fed, recently cautioned that if bond market investors in the US start factoring in higher inflation, it could serve as a significant warning that might disrupt policymakers’ plans to reduce interest rates.
While longer-term inflation expectations remain more stable, with the five-year swap hovering around 2.5%, this suggests that bond markets perceive the trade tensions and other Trump policy-related inflationary effects as short-lived. Bond fund manager Mike Riddell from Fidelity International indicated that tariffs are seen as short-term inflationary factors, although deeper supply chain issues could prolong their effect.
If central bankers judge that the tariff-induced price increase is a temporary shock, they might prioritize mitigating economic impacts on demand and employment. However, recent inflationary experiences post-pandemic keep price expectations sensitive.
Gennadiy Goldberg, head of US rates strategy at TD Securities, remarked that current market trends suggest they view this as a potentially transitory inflation burst. Conversely, Andrew Clare from Bayes Business School noted the tariffs present an unwelcome challenge for central bankers.
The crucial question remains regarding how central banks, especially the Fed, will address a potential rise in inflation. Increasing rates could further burden businesses and consumers, while doing nothing or cutting rates to stimulate demand might exacerbate inflation. Investors noted that the significant change in short-term expectations is pronounced given the recent fall in oil prices and simultaneously rising consumer inflation expectations.
Prior to Trump’s announcement, Dan Ivascyn, chief investment officer at Pimco, highlighted the ongoing risk in an environment of elevated inflation potentially becoming more entrenched.
