Overreach?

It could be the beginning of the end for the American empire…

Long dated Treasury yields were little changed over the past week, with the FOMC meeting emphasising a sense of macroeconomic uncertainty, amidst ongoing policy announcements, which are seen as depressing growth and raising inflation over the course of the coming months. In a sense, market participants are already looking ahead to the April 2nd deadline, when we have been guided to expect the next major developments around tariffs and trade policy.

In this respect, we expect the US to hit the EU with 25% tariffs, in line with what has already been seen in the examples of Canada and Mexico. With the EU ready to hit back and some EU officials we have met with citing that ‘the bloc stands ready to test Trump’s pain threshold’, our sense is that trade tensions will only escalate in the short term, and that this represents a challenge to risk assets. In the coming quarter, ‘Trade Wars’ could become a dominant theme.

However, we are more hopeful that by the end of 2025, penal 25% tariffs will have been replaced by a more moderate stance, with executive orders giving way to tariffs, which are legislated through Congress.

Speaking with officials in Washington, there is a sense that their tariff agenda is fully justified, given that the US imposes no federal sales tax, in the way other countries will apply such taxes to US exports. Moreover, they feel that their position as the world’s dominant superpower means they will be able to leverage the outcomes they want, as others won’t be able to resist them.

Yet, an Achilles heel in this thinking may be that the imposition of tariffs will operate as a negative supply shock, in economic terms. As tariffs are imposed, then this reduces consumption (lowering growth), whilst raising inflation.

A shift higher in inflation may be compounded by disruptions to supply chains and although some commentators will seek to claim that such an inflationary shock will only be transitory, meaning the Fed can cut rates in response to slowing growth, we have seen the dangers of this type of thinking as recently as 2021.

In this case, Covid was also an adverse supply shock, and it was seen how easing monetary policy into a supply shock means there is capacity for this inflationary move to become more pronounced.

As this then feeds into elevated wage demands and secondary price shifts across the economy, this eventually means that interest rates will need to go much higher for longer, in order to re-anchor inflation expectations and restore price stability.

With Donald Trump – and Scott Bessent as his subordinate cheerleader – already calling for the Fed to look through higher near-term prices and proceed with additional rate cuts, it seems that the pressure on Powell and the Fed is only likely to grow as the economy slows. Yet, the truth is that monetary policy is not a policy tool equipped to handle supply shocks and, in this respect, fiscal policy is much more relevant.

In Europe, we have already seen how Germany is unleashing a substantial fiscal easing, which we see echoed across the Eurozone, given the need to increase defence expenditures. This may help cushion the EU economy from a building trade war, in the eyes of EU policymakers we speak to. However, in the US, the large federal deficit leaves no room for further fiscal easing.

Indeed, Trump avows to be committed to cutting US debt. In this respect, we are sceptical and expect DOGE cost savings to be used to finance lower taxes, not for deficit reduction.

Yet with Musk’s job losses coming first and already impacting consumer sentiment, and the benefits of tax cuts only being felt later, so we think that the short-term fiscal position in the US is more contractionary than expansionary, for the time being.

This being the case, if the FOMC is unable to deliver the rate cuts Trump would like to see, the US could yet end up as one of the biggest losers in a trade war, which it is responsible for instigating.

Returning to fixed income markets, our sense is that it will be difficult for yields to rally by much, even if growth does slow in the months ahead. For now, a recession in the US remains unlikely, but a period of below trend growth is seeming largely probable.

In this backdrop, we continue to think it makes sense to determine where we consider fair value for yields and, thereon, levels at which we would be happy to buy or sell exposure. From this standpoint we would see 10-year Treasuries around 4.5% as fair value. 10-year yields look to be a sell below 4.2% and look more of a buy as we approach 4.75%.

Should risk assets come under pressure and lead yields lower in the near term on a flight to quality, we are inclined to add to a modest short duration position, which we incepted two weeks ago, the last time that this threshold was breached.

In FX markets in the short term, we think that the dollar could make some gains over the coming week. With the April 2nd deadline looming large, we think that over the past couple of weeks, the market has moved long of euros and this position could be pressured as investors look to trim risk ahead of announcements.

Also, a large outperformance of European stocks relative to the US and other global markets in the past month may lead to some month-end rebalancing flows, creating a short-term demand for the US dollar.

That said, we are more doubtful on prospects for the US dollar over the medium term and although we don’t think the time is right to chase a weaker dollar theme, our structural thinking is moving more in this direction, based on the view that with growth and interest rate differentials narrowing, so the era of US-led growth exceptionalism is coming to its end.

In discussions with policymakers in Europe this week, we have been looking at how money is expected to be spent in the context of the intended defence and EU SAFE initiatives. Inasmuch as supply chains need to be rebuilt, our takeaway is that spending on infrastructure projects will likely come with a higher fiscal multiplier than is typically associated with defence spending.

In this way, we would be inclined to see upside risks to our own 1.5% EU growth projection, were it not for the trade uncertainties coming from the other side of the Atlantic. We continue to think that it is unlikely that the ECB will want to lower rates further, given that there are upside risks to inflation, and the EU labour market remains relatively tight.

On a number of measures, there is not much slack in the economy and with a fiscal easing which is potentially larger than what was delivered at the time of German unification, there won’t be room for easier monetary policy if fiscal policy is being deployed this assertively.

We also remain sceptical in terms of the chances for future UK rate cuts. Despite a weak economy, UK wage growth continues to grow around 6% on an annual basis. There is no way that this is consistent with 2% inflation, in an economy devoid of any productivity growth, and it strikes us that inflation expectations have already settled into a 4-5% type of range.

Meanwhile, elevated borrowing costs are pressuring UK government finances. In this respect, Rachel Reeves has been working with government departments in search of elusive cost efficiencies. However, the government seems unwilling, or unable, to tackle runaway social welfare spending in a country that seems to have become addicted to benefits and state handouts, in a society that increasingly seems to devalue hard work.

Given that the tax burden is historically very elevated and is causing wealth creators to look to move overseas to lower tax jurisdictions, so Starmer’s government is caught between a rock and a hard place, and one wonders whether a bigger crisis will be needed to prompt a more radical change.

Yet for now growth remains anaemic, inflation remains problematic, and we see an opportunity to sell 10-year gilts at levels below 4.5%. Meanwhile we also think that burgeoning stagflation risks will eventually end up weighing on the pound.

In Japan, this week’s BoJ meeting passed without too much interest. We expect the Shunto wage round above 5% to reaffirm the next cash rate hike to 0.75% by July, though domestic political issues could impact on the timing of the BoJ’s decision, with Ishiba looking weak ahead of Upper House elections also taking place in July.

Elsewhere, Turkey was in the limelight this week for many of the wrong reasons, with the arrest of Ekrem İmamoğlu, the leader of the country’s opposition and main rival to Erdogan. This prompted weakness in Turkish assets, which saw the lira drop as much as 10% on the day, before recovering. Politically speaking, this news isn’t seen in a constructive light, but at a time when political strong-men seem to be on the ascendant globally, one wonders how much this will come to matter at the end of the day.

Credit markets remained relatively calm over the course of the week, with equities also stabilising after a couple of rocky weeks. As highlighted above, we think that the upcoming trade announcements on April 2nd could serve as a renewed catalyst for volatility in risk assets, and so we retain a relatively cautious stance.

It was also interesting to observe that AAA-rated CLO spreads have widened by as much as 20bps following a flurry of CLO issuance in recent weeks. This points to some short-term indigestion, though thematically, owning high-quality carry as a defensive trade looks to have appeal for those strategies able to take this exposure.

Meanwhile, a return to conflict in Gaza, which seemed depressing and predictable in equal measure, registered negligible market impact. Yet with Putin also thumbing his nose at Trump in this week’s phone call with the White House, there is a sense that the US President’s mantle of invincibility is looking more questionable, on multiple fronts, as the days go by.

In terms of currency, we continue to favour the yen with respect to narrowing growth on interest rate differentials, pressure from policymakers on both sides of the Pacific to strengthen the yen, anticipated portfolio shifts favouring domestic assets from Japanese investors, and valuations which are compelling in favour of the Japanese currency.

Additionally, should a risk averse environment develop, we also think that the yen may be a top performer in a flight to quality and, in this way, can represent an attractive risk-off hedge in portfolio construction.

Looking ahead

Next week sees the end of the first quarter of 2025. At times in the past few months, it has felt like there was so much news bombarding us as investors, that it has been difficult to keep up. At a time of considerable economic uncertainty, it feels that one thing we can continue to be confident about is that this new regime of political volatility seems set to stay.

Indeed, stepping back from the noise, we find that we’re asking ourselves how significant some of what we have recently witnessed will prove to be on a long-term basis. For example, have we seen the end of US growth exceptionalism and with it the period of US hegemony in global capital markets?

Time will tell, and it would be wrong to write off the US prematurely, though it strikes us that if TINA (‘there is no alternative’) was a strategy driving flows into US stocks in 2024, so in 2025 we may come to realise that in equity markets in Europe and elsewhere, we have passed a point of maximum bearishness. There could be scope for a sustained revaluation, should asset flows re-route back towards domestic markets, with this being a trend that policymakers may well seek to encourage.

There is no shortage of themes for us to ponder at the current time, but perhaps the biggest one of all relates to whether US hubris, personified by Trump, has led to a point of overreach, which may come to have profound political and economic consequences.

Some commentators may want to ponder on ideas around ‘the End of Empire’, which is almost certainly taking things too far. That said, it is worth reflecting for a moment how it has been that global flows into US stocks have created US wealth effects, further boosting US consumption and US asset prices, thus attracting ever more flows in the process.

As and when this cycle goes into reverse, the landscape could look very different indeed. Undeniably, if Trump’s policies and behaviour are the catalysts that bring about such changes, then the ‘America First’ agenda may end up coming back to haunt the USA in years to come.