Big policy shifts reinforce higher rates
U.S. tariffs and Europe boosting fiscal stimulus reinforce our view of policy rates staying higher versus pre-pandemic levels. We go underweight euro area bonds.
U.S. stocks slid 3% last week on market concerns about policy uncertainty. German bond yields jumped the most since 1990 on big fiscal spending plans.
We think solid, if slowing, job growth and persistent wage pressures should show sticky core inflation in next week’s February U.S. CPI data.
Germany’s planned fiscal boost and the U.S. starting to levy hefty tariffs are major policy shifts. Policy uncertainty and bond yield spikes pose risks to growth and stocks near term. We see more upward pressure on European and U.S. yields from sticky inflation and rising debt levels, even as lower U.S. yields suggest markets expect a typical Federal Reserve response to a downturn. Yet we think mega forces like AI can offset these drags on stocks, keeping us positive over six to 12 months.
Return of tariff
U.S. effective tariff rate and potential 1900-2025
The U.S. briefly rolled out the largest tariffs in nearly a century on March 4: 25% tariffs on most Canadian and Mexican imports and an extra 10% on China. While most North American tariffs were later put on ice for another month, we think an average effective tariff rate of about 10% could be the eventual landing zone – with volatility along the way. See the chart. What matters more for near-term growth: any pain due to elevated uncertainty, including a potential U.S. government shutdown. Markets expect weaker U.S. growth to push the Fed to cut policy rates as in a typical business cycle. Yet we see a tough trade-off between supporting growth and curbing sticky inflation, limiting how much the Fed can cut. That reinforces our expectation of rates above pre-pandemic levels and higher bond yields. Germany’s plans for big defense and infrastructure spending mark a major fiscal policy shift.
Our scenarios framework – mapping potential outcomes for different mixes of growth, inflation and policy responses – helps us navigate this evolving market and economic landscape. In the past few weeks, markets have been increasingly pricing in a potential recession. We disagree. Why? Job creation has slowed slightly but the labor market remains strong in contrast to soft survey data showing declining consumer confidence. U.S. corporate earnings are also holding up. We still think earnings strength can broaden out beyond tech and to other regions as the buildout and adoption of artificial intelligence progresses. While heightened policy uncertainty will drive near-term market volatility, these other drivers keep us overweight U.S. stocks.
Long-term U.S. Treasuries have rallied as recession fears grip markets. Yet they don’t reliably buffer against equity selloffs given persistent inflation. And yields could spike suddenly. One reason: Higher-for-longer Fed policy rates and persistently large fiscal deficits – even with tariff revenue and spending cuts – could push investors to demand more compensation for the risk of holding long-term bonds. We stay underweight long-term Treasuries, preferring short-term notes for income.
This pressure on yields is global. German bunds suffered their sharpest selloff since 1990 after the parties set to lead Germany’s next government agreed to a €500 billion infrastructure fund and axed deficit limits on defense spending. These plans – to be voted in parliament next week – come as the U.S. says Europe is no longer a top security priority. The European Union also proposed amending its budget rules to up defense spending. Europe could face higher-for-longer rates like the U.S. as greater government borrowing and spending stoke inflation. Plus, the European Central Bank is nearing the end of rate cuts. That’s all why we think euro area sovereign bond yields can rise further and go underweight. We trim our underweight to Japanese government bonds: yields have surged to 16-year highs. Yet we still see room for JGB yields to keep rising in a world of elevated debt levels and higher inflation.
Bottom line: U.S. tariffs and Europe’s plans for a fiscal boost reinforce our expectation of higher-for-longer interest rates and bond yields. We go underweight euro area bonds. Policy uncertainty could keep weighing on U.S. stocks near term.
Market backdrop
The S&P 500 slid 3% last week, its biggest weekly drop in six months and dragging the index into negative territory for the year. Ten-year U.S. Treasury yields were flat on the week but about 50 basis points below the year’s high, while 10-year German bund yields jumped about 45 basis points last week – the largest surge since German reunification in 1990. U.S. payrolls data showing slower but still solid job gains suggests market concerns about a recession are overdone, in our view.
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