Unfunded tax cuts, outlays on defense and infrastructure as well as rising inflation expectations are pushing global bond yields higher, which will put at risk private sector investment as investors demand higher returns for lending to sovereign governments.
Investors facing uncertainty over fiscal and trade policy have started to sell long-term assets and are favoring perceived safe-haven investments, or even cash and its equivalents.
While the notion of sovereign risk is nothing new, the fiscal imbalances among major economies, fueled by deficit spending and rising inflation, have increased the cost of capital globally.
In addition, rising inflation expectations amid an imposition of tariffs will push up prices of intermediate and final goods, which further obfuscates the outlook for inflation.
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For investors, each tariff pronouncement only heightens the uncertainty regarding inflation and the direction of global commerce.
For the United States, the bond market selloff at the long end of the yield curve had a false start in March, only to become a full-fledged rout after the tariff announcements on April 2.
As we show, the direction of inflation expectations, as measured by the five-year, five-year forward inflation expectation rate, has a near one-to-one impact on U.S. 10-year Treasury yields.
U.S. inflation had dropped from its average of 3.0% last year to 2.3% by April, but now is expected to move back to 3.0% this year.
Economists’ forecasts of U.S. inflation for this year range from 1.9% to 4.5%, with low estimates likely because of heightened forecasts of recession and higher forecasts likely because of anticipated stagflation.
There are similar ranges for estimates for inflation in the United Kingdom and Japan, where consumer prices have turned hot, and in Germany, where government spending has increased in an effort to address a decline in manufacturing and uncertainty over its security.
Looking back for some guidance, the tariffs of 2018-19 trade war were more limited and came at a time that China was producing an abundance of cheap goods.
Market-based inflation expectations fell from 3% to 2% in 2019 and to 1% in 2020 as demand dropped during the pandemic shutdown.
This time around, though, tariffs are being applied to almost all goods entering the U.S., with particularly onerous tariffs on Chinese-produced goods, which is sending inflation expectations to 5%.
The result has been rising uncertainty, which will harm consumer spending and business investment as the cost of credit increases.
