TACO Trump is likely to fight back

The President’s tariff flip-flopping has earned him an unfortunate nickname!

A New York court ruling against President Trump’s implementation of IEEPA tariffs via executive order has added an additional element of US policy uncertainty over the course of the past week. Our sense is that this ruling itself will be overturned in the Supreme Court.

However, in the interim, it seems likely that trade negotiations may go on the back burner, as other countries wait and see how the legal process unfolds. This could mean that Trump needs to extend the 90-day extensions on the additional tariffs that he announced on ‘Liberation Day’, though we very much doubt that the President will be moved to change his agenda in a material way.

Ultimately, our analysis on US tariffs suggests these will normalise at around 12-14% of goods imports, (subject to substitution effects) assuming tariffs remain as they are. We see this contributing USD250-300 billion in revenues (around 1% of GDP), which are needed in the Budget, and think that it makes sense to consider this amount as a type of embedded consumption tax hike.

We think that the tariff effect may lower the growth trajectory to around 1.5% for the next 18 months. In addition to reducing consumption due to tariffs, as prices increase, a slowing of growth also allows for an increase in uncertainty that seems set to persist. Uncertainty acts as a deterrent for businesses to invest and a disincentive for consumers to spend on large ticket items.

On this former point, we would note that decisions to build new factories will typically be taken on an 8-10 year view. Consequently, any decision to re-shore production needs to be tempered by the risk that there is a change of administration in 4 years’ time, and they could take a very different stance on trade and tariffs.

Meanwhile, we see US core PCE inflation between 3.0-3.5%, as prices adjust during the coming period. This being the case, it is hard to project any Fed easing in the coming six months or more, unless growth is materially slower, leading to a jump in the unemployment rate, or absent a large disinflationary offset coming elsewhere, which appears difficult to foresee.

On unemployment, we think that the clampdown on immigration will act to limit any rise in jobless totals, even if growth is below the potential trend rate. As for inflation, with the dollar having weakened in 2025, it seems that FX won’t be a channel that can offset tariff increases.

Turning to the US Budget, we continue to project a deficit in 2025 around 7% of GDP, after allowing for these shifts. Essentially tax cuts and higher defence spending are set to be funded by an increase in taxes (via tariffs), with DOGE cuts viewed as largely irrelevant.

Global 10-year bond yields were not much changed over the course of the past week, with bond markets lacking a clear trend from a directional point of view. However, this tells only part of the story. Yield curve slopes have been much more volatile, with long-dated bonds being driven by concerns relating to rising debt levels, coupled with technical developments linked to supply and demand.

In this context, Japan has been a particular focus over the past several days. In recent weeks, long-dated Japanese bonds have been under particular pressure, in the absence of domestic demand, at a time when volatility has deterred potential buyers. Investors had been concerned with respect to a tone deaf approach by the Ministry of Finance pertaining to their issuance plans, in the wake of a messy auction of 20-year securities last week. This subsequently saw Japanese 30-year yields exceed 3.2%, a figure double that offered by 10-year maturities.

However, an announcement this week – that the authorities in Tokyo were now prepared to respond to market conditions by paring long date issuance – has seen a marked turnaround. This has since seen a flattening of the Japan 10/30 curve by more than 20bps and helped ensure a more successful auction of 40-year securities.

The pronounced flattening at the long end of the Japanese curve saw similar global moves in sympathy. Deficit concerns had pushed the US curve steeper in the prior week and, despite this move reversing in the past few days, we think that worries around mounting debt levels are unlikely to abate any time soon.

In contrast to Japan, the US curve remains relatively flat, and we think that a steepening trend could re-emerge over the coming weeks. For the time being, 30-year Treasuries have found buying support around 5.0%. Yet, we are concerned that, as US debt grows at a time when a majority of overseas investors appear inclined to reduce their asset allocation towards US assets and the dollar, so it will be contingent on US domestic investors to absorb the additional supply as debt levels grow.

In this context, retail engagement in fixed income will be important, although for the time being it is tempting to think that this investor group is much more focussed on buying any dips in the equity market and chasing stock prices higher, or alternatively piling into crypto currencies at the encouragement of President Trump and others.

In this respect, it is interesting to question how high 30-year yields would need to rise, if they need to find retail support. For example, from this standpoint, it may be tempting to think that such investors may want to see yields at least 200bps above what is offered by money market funds, in order to compensate them for the additional risk and potential volatility.

In this case, it is not difficult to build a scenario where 30-year yields eventually rise to 6%, or even higher, if supply fails to find sufficient demand. In this context, we have noted that many sovereigns have been deliberately shortening the profile of their debt, reducing longer-dated supply. Yet as the total debt level rises, so the risk of a buyers’ strike will always loom, as a potential threat in the back of investors’ minds.

In Europe, bond market moves have been more muted than elsewhere. Fiscal policy is being eased and this leaves us sceptical that the ECB will lower rates below 2%, given projected growth close to 1.5%, matching the US in the months ahead, and based on our analysis. However, the inflationary outlook is more uncertain to predict.

On the one hand, we expect some EU retaliatory tariffs to be implemented on US imports, and this may raise regional prices somewhat. However elsewhere, deflation in goods prices as Chinese exports head towards Europe in greater quantity can help lower inflation. Of course, this depends on whether the EU also raises trade restrictions to protect its own producers, on fears of economic dumping.

If the inflation picture is this opaque, what does come across more clearly in conversations with EU policymakers is the strong commitment to boosting defence spending, building supply chains and adding capacity. However, this particular story seems to be much more relevant to equity rather than fixed income investors.

In the UK, there have been suggestions that Labour is looking to loosen the fiscal framework, which is constraining government spending. Although it is hard not to have some sympathy in this respect, as Labour has inherited a straitjacket of the making of the past Conservative government, there is a risk nonetheless that the gilt market takes unkindly to these plans.

On a more positive note, UK growth seems more robust than had been feared and this may help support the fiscal maths. Yet, the offset to this is that news on inflation continues to worsen, with the British Retail Consortium reporting the fastest inflation in UK grocery prices for the past 15 months. In this context, it strikes us that UK inflation (and inflation expectations) is set to settle around 4%.

That said, it is concerning to see junior doctors even pushing for a 29% pay hike. Although this may highlight very specific factors within this cohort, the reality is that for many in society the level of experienced and perceived inflation is substantially higher than that recorded in the official CPI statistics.

Credit markets remained relatively quiet over the past week with little newsworthy to report. Within the EU sovereign market, spreads have continued to grind tighter, and in this respect, we are looking at the French OAT spread with a view to moving towards a short stance.

That said, it is striking to observe that Greece government bonds trade within 5bps of OATs in 10-year maturities, and absent political volatility, we could see a summer of spreads grinding tighter, in the absence of new news. In FX, price action has been rangebound over the past week. The notion of a long-term trend shift towards a weaker dollar appears supported by numerous client meetings in which asset allocators have shared that cutting US exposure is a matter of consideration.

In this respect, a world in which tariffs rise and trade restrictions are imposed infers a world where trade volumes are likely to moderate. In this respect, if patterns of consumption reflect a bit more of a home bias, then we think it seems likely that a greater home bias in terms of investment is also likely to be witnessed in the quarters to come.

Looking ahead

In many respects, it appears that most markets have been moving sideways, without a clear directional trend for the past couple of weeks. However, it would seem to be foolhardy to expect these conditions to prevail for much longer, and there has been a sense since the start of this year that it is hard to predict what sits waiting for us around the next corner.

Indeed, if it has been a difficult environment to predict for many economists and investors, the same has been true for central bankers, such as the Fed. In this case, we should reflect that central bank forward guidance won’t count for much. Instead, policymakers will need to be reactive, rather than pre-emptive, in terms of their decision making in this environment. This suggests that the Fed is likely to end up behind the curve at some point, though Powell is likely to be relatively relaxed with rates around current levels if he is seeing 1.5% growth and only a slow rise in the rate of unemployment.

At a time when overall market direction is less certain, it does strike us that curve trades offer a better potential reward than duration trades at this juncture. We would also observe that many investors have historically sought to own duration as a ‘risk-off’ hedge to other positions that they own.

However, owning duration seems a much less attractive hedge at a time when one of the principal risks to equity markets could come through a continued move higher in long-dated yields. From that point of view, a curve steepening position appears to have much better merit as a ‘risk-off’ hedge.

As well as benefitting in an environment where debt concerns pressure long-dated yields, curve steepeners should also outperform should a renewed escalation of trade tensions raise concerns of slower growth and a possible recession.

Whilst acknowledging that the steepening trade in the US is a consensual view, which has a negative yield carry, we think that an asymmetric risk profile, allied to portfolio construction benefits makes this an attractive time to add to this position.

Meanwhile, just as market participants start to reassure themselves that we are in a TACO moment (Trump Always Chickens Out), we do see a risk that this narrative could embolden the President’s next move. There is a risk of complacency in the TACO view. It strikes us that the hot sauce could easily kick in, just when markets least expect it….