5-D chess

An ever-evolving geopolitical chessboard

A material policy pivot saw the US cut China tariffs from 145% to 30% for the next 90 days, with Beijing similarly reciprocating with its own tariff reductions. This news came as a surprise to financial markets. It prompted a material reduction in US recession fears, which had been building on a growing concern of widespread supply chain disruption.

Chinese tariffs now sit 10% above the level that was in place at the start of 2025. This increment is in common with other countries globally. It would appear that Trump has backed away from the idea of a broader trade war. Although it seems likely that tariffs could rise, in the absence of further deals being negotiated, markets have been happy to conclude that a more pragmatic agenda is now in play.

Indeed, it is interesting to note that compared to the day of the US election on 5th November, the S&P is now higher, interest rates are lower, inflation has fallen, oil prices are down, the dollar is weaker, tariff revenue is up, and the economy remains at full employment. There is even a US Pope. Short of securing a peace deal between Russia/Ukraine (yet), suddenly the first 100 days in office don’t seem to be going too badly, when looked at this way!

Trump has continued to sow confusion and concern, but you can understand why some have even been moved to observe that, actually, the President must be engaged in a clever game of 5-D chess, with the rest of us left scratching our heads in the master’s wake. Mind you, it could be just as tempting to build a narrative that we have all managed to be fooled by randomness along the journey.

In the absence of an escalating trade war, we would now guess the run rate of US GDP growth at around 1.5%. However, we have been revising these estimates so much in response to developments lately, you may wonder if there is too much merit in relying on longer-term economic projections!

With respect to inflation, this week’s CPI report was relatively benign at 2.8% on the core measure, although upside risk to prices, as a result of tariffs and supply chain disruptions, could see higher numbers in the months ahead. Anyway, it strikes us that the Fed can sit vindicated in its decision to stand pat on interest rates. At the press conference following last week’s FOMC, it appeared many of the journalists asking Chair Powell questions seemed to share President Trump’s frustration that the Fed Chair was reluctant to give too many clues with respect to forthcoming rate cuts.

Yet, newsflow in the past week shows why the central bank can’t get pulled into a game of guessing where the economy may go, based on survey indicators and the latest policy announcements, in an environment of such uncertainty. Instead, they need to retain discipline with respect to analysing hard economic data and adjusting policy so as to minimise any overshoot on inflation or unemployment that would take them in a direction away from their desired objective.

We continue to see the Fed on hold for the next couple of quarters. Later in the year, prospects for rate cuts materially outweigh those for hikes. In this context, we have thought that fair value for 2-year Treasuries is around 4%.

With yields moving up in the past week, futures markets now only discount two Fed cuts later this year, in line with the March dot plot. This is a material adjustment to the four rate cuts being priced as little as a couple of weeks ago.

Meanwhile, 10-year yields at 4.5% also appear reasonable, though we see risks toward higher yields at the longer end of the curve. 30-year rates may breach 5%, partly as recession fears recede, but also, in part, as debt investors focus on the concerning state of the US Budget.

Budget discussions up to this point would seem to infer a deficit, which will continue to remain around 7% of GDP in the coming year. Yet even this figure will only be achieved if growth (and therefore tax revenues) holds up.

Also, this outcome additionally appears to assume that annual revenue from tariffs will be around USD250-300 billion (approximately 1% of GDP). Should tariff revenue fall short, then the deficit could continue to edge higher. Talk of DOGE cost savings benefitting the Budget now appear to be a fading mirage.

Meanwhile, hopes that yields would fall, thus lowering borrowing costs, have also been dashed for the time being. Consequently, we remain in an environment of increased government bond issuance. With overseas participation in Treasuries prospectively on the decline, higher yields need to attract capital from elsewhere. In this way, there is a risk over time that this leads to a ‘crowding out’ of the private sector and could adversely impact longer-term growth and credit spreads.

However, up until now, higher government bond yields do not seem to have dented enthusiasm for risk assets much. The past week has seen investors remove recession hedges and re-engage with risk assets, as fears in the near term have been pushed to the back burner.

Indeed, high absolute yields can initially encourage credit investors, such as insurers, who maintain nominal yield targets. However, with markets having reversed most of their previous 2025 year-to-date losses, there is limited scope for further compression, and the way the year has played out, it would take a brave (or foolhardy) investor to expect that we have witnessed the end of Trump-induced volatility. On this basis, we feel that it continues to make sense to pare risk into strength and await clearer opportunities ahead, as they present themselves.

In Europe, there has been some renewed attention on French politics and the potential vulnerability of the Bayrou government. A near-term collapse and new elections seem unlikely at the moment. However, the need for France to deliver spending cuts to avert further growth in the fiscal deficit remains a fault line that can easily become exposed.

With Germany loosening the fiscal reins and a push for greater EU defence spending, this highlights that much of the required spending may need to be done at a joint EU/ESM level, rather than putting pressure on national budgets. Elsewhere, this weekend sees elections in Poland and Romania.

In the case of the latter, hopes that the more mainstream candidate, Dan, is closing in the polls on his rival Simion, have helped asset prices to bounce from last week’s lows. However, we think that the most important point is that a coalition government can be formed without new Parliamentary elections being called, which would be a catalyst for further turbulence and rating downgrades.

In Japan, we have been surprised that declining fears over the US economy have not raised expectations that this will enable the BoJ to continue to normalise monetary policy as we move through 2025, with wages and price inflation well ahead of the central bank’s 2% target. Arguably, the fact that the central bank is behind the curve is putting upward pressure on longer-dated yields.

We think that, with the yen having also reversed a chunk of its prior gains versus the dollar, there is a building case in favour of the BoJ hiking rates at its meeting in July. As we believe that rates markets materially underprice BoJ rate hikes, we have added a short position in Japanese yen 2-year swaps at a yield of 0.70%.

We think that cash rates will soon rise from 0.50% to 0.75% and that further interest rate hikes will see the BoJ lift the cash rate to 1.0% at the end of this year and 1.5% by the end of 2026.

Looking ahead

It seems that we are left continuing to look at the next policy moves of the US administration as the main driver of volatility and price action. Economic data is likely to be benign, though some of the supply chain disruption that will be linked to the elevated tariffs on China at the start of April will still have some effect and could create a bit of economic noise.

Meanwhile, if the US is really able to raise around 1% GDP from tariffs, this will inevitably still mean somewhat higher prices and weaker consumption. As for US trade policy, attention will be focussed on who else is getting a deal done with Washington in the next few weeks. Conversations with Canadian and European policymakers have reflected that the UK deal was a poor deal for the UK, and certainly won’t be a template for the sort of concessions that they, themselves, are likely to be prepared to give.

Furthermore, the fact that the US may appear to have ‘gone soft’ on China might mean other countries are more inclined to hold to their own positions and less likely to give up ground, just to get a deal done. How this may play out is still uncertain.

Yet, it could prove complacent to think that Trump has now dropped his hopes, to effect material change. Efforts around the DOGE and the Budget seems to be amounting to very little. However, on trade, it is hard to see the US climbing down much more than it already has. It remains a determination of the administration to end US dependency on China, which is seen as a threat to future prosperity, as well as security.

In this respect, it may be worth reflecting that with Trump, policy does not move in a straight line. Pre-empting Trump’s next moves certainly seems no easy task. Indeed, we have learned that there are times when even those inside the administration are left guessing and are shocked by tweets as much as the rest of us. This makes for no shortage of head-scratching within the investment community. 5-D chess seems like an overly-generous characterisation. Surely Trump is just making up his moves as he goes along…