Markets Weekly: Trump vs the World Puts Rate Cuts at Risk

President Donald Trump's aggressive trade policy has thrown down the gauntlet, not just to America's trading partners, but also to the Federal Reserve. With a flurry of new tariffs, threats of more to come, and a clear desire for lower interest rates, Trump has created a highly uncertain economic landscape that puts the Fed in a precarious position. The central question is no longer just if the Fed will cut rates, but how a potential trade war will force its hand.

On Monday, Trump imposed a 25% tariff on all steel and aluminum imports into the US with no exceptions or exemptions. He has also increased tariffs on Chinese goods to 10%, with promises of reciprocal tariffs on any country deemed to be engaging in unfair trade practices:

The president said that under the plan, the U.S. will treat other countries’ non-tariff policies as unfair trade practices that warrant tariffs in response. Those include value-added taxes, or VATs, and other practices that the office of the US trade representative deems to be unfair trade limitations. (CNBC)

Trump stated that his administration would prevent foreign countries from circumventing U.S. tariffs and trade restrictions by routing their goods through intermediary countries.

This policy, encompassing even close allies like Canada and Mexico (though temporarily spared from some tariffs), has sparked immediate concern about a full-blown trade war. Predictably, retaliatory measures are already being implemented or threatened:

The EU, Canada and Mexico have countermeasures ready to inflict economic pain on the United States in response to Trump’s actions, while China has already taken retaliatory steps with its own tariffs on U.S. energy, agricultural machinery and large-engine autos as well as an antitrust investigation of Google. (AP)

One of the most immediate economic consequences of these tariffs is likely to be higher inflation. By increasing the cost of imported goods, tariffs act as a tax on consumers and businesses. The National Retail Federation issued a stark warning, suggesting that the tariffs "will likely result in higher prices" and "erode household spending power".

Beyond consumer goods, the tariffs are also expected to drag on US GDP growth. "We would expect that growth in the US would probably slow by a quarter point or so," says Joseph Briggs of Goldman Sachs during a podcast interview.  

This combination of higher prices and slower growth puts the Federal Reserve in a particularly difficult position. The Fed's dual mandate is to promote maximum employment and stable prices (defined as 2% inflation). Higher inflation, driven by tariffs, would call for the Fed to maintain higher interest rates, or even raise them, to cool down the economy and prevent prices from spiraling out of control. However, a trade war also carries the risk of slowing economic growth, potentially leading to job losses. Slower growth would typically call for the Fed to lower interest rates to stimulate the economy.

Given this conflicting set of pressures, the Fed, for now, is likely to hold interest rates steady. In his Wednesday testimony before Congress, Fed Chair Jerome Powell stressed that the FOMC did "not need to be in a hurry to adjust policy stance." and pointed out that they can "maintain policy restraint for longer" if the economy remains strong and inflation proves persistent.

He also noted that the fed funds rate was "significantly less restrictive than it had been" – this implies that the Fed still views its monetary policy as restrictive and rate cuts will be needed at some point.

This cautious stance reflects the Fed's attempt to navigate a contradictory set of economic signals. Powell remained somewhat muted on his views on tariffs, reiterating that “it would be unwise to speculate” on the economic impact of the new administration’s trade policies, and that it "remains to be seen what tariff policies are implemented."

Consequently, the market now sees tariffs as the main risk for inflation and source of uncertainty. As Michael Rosner of Raymond James puts it:

[Tariffs] pose a threat to the recent progress made on inflation. While Wednesday's CPI is an important input into the Federal Reserve's thinking on rates, we may be 6-8 months away from the next rate cut, so it's premature to put much weighting on what this data point means for the Fed. Barring any major changes to the near-term economic data, we don't think the Fed is going to pivot from its 'wait and see' approach on rates

Reflecting this view, the market is pricing in fewer cuts than previously anticipated. According to the CME FedWatch Tool, the market is pricing in a 97.5% probability that the Fed would pause rate cuts at its March meeting, up from 76.3% just one month ago.

Long / Short

Crude oil: "Crude demand clings by a thread. Even with all the hype around Artificial Intelligence and data centers, we believe global energy consumption should grow below 3% YoY into 2030. In turn, oil use may struggle to grow above 1% annually." (Bank of America)

Equities: "For equity markets, we think that 2025 is all about earnings growth, not multiple expansion. As such, we expect positive, though much more modest, returns than in 2024. As part of this thesis, we think market breadth will improve both domestically and internationally." (KKR)

S&P500 concentration: "In terms of how we’re assessing the concentration of the S&P 500 today in the Mag 7, while it is unusual to have this much concentration in the top seven names, it is not unprecedented... This level of concentration among the top seven companies was last seen in the 1950s and 1960s, when the largest companies included AT&T, General Motors, and DuPont. This was actually a strong period for US equity returns, both for the mega-caps of the time as well as more broadly." (Bridgewater)

Bonds: "We find that corporate credit spreads respond as expected to tariff policy shocks – widening when tariffs are imposed and tightening when they are relaxed. A simple rule of thumb suggests that for every $10 billion increase in tariff revenue USD IG and HY index spreads widen by 2bp and 13bp, respectively. While counteracting movements in treasury yields can act as a hedge for total returns, we do see tariff risk as one of the likeliest potential catalysts for a rebuild in credit risk premia in 2025." (Goldman Sachs)

Quick Hits

• Dalio's Debt Warning: Ray Dalio issues stark warning of an "economic heart attack" for the US unless drastic debt cuts are implemented, comparing the situation to a serious medical emergency requiring immediate attention.
• Fed Sees Progress on Inflation: Fed's Williams expresses confidence that current short-term interest rate levels are on track to curb inflation and bring it back down to the central bank's 2% target, citing the effectiveness of current monetary policy.
• Gold's Safe-Haven Surge: Gold is set for a seventh consecutive weekly gain as trade war fears intensify following President Trump's push for reciprocal tariffs, with spot gold up 0.3% at $2,936.79 an ounce and hitting a record peak of $2,942.70 earlier in the week.
• European Stocks: Party's Over Soon?: Despite new record highs potentially fueled by talks to end the war in Ukraine, European investors are beginning to wonder if the region's hot stock winning streak is sustainable, amid concerns about long-term economic fundamentals.

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