Move beyond the headline noise to assess the investment implications
Tariff headlines continue to drive significant market volatility, with the potential long-term effects of the Trump administration’s proposed and imposed tariffs yet to be fully understood. As we attempt to separate the noise from the lasting impact of tariffs, we will be watching the direction of the US dollar and Treasury yields.
Broadly speaking, the current tariff framework includes two types of tariffs:
First-mover tariffs are designed to increase the cost of goods imported into the US from abroad. This kind of tariff could raise the risk of higher inflation as it will prove to be a price shock that companies will attempt to pass along to consumers. Higher inflation expectations will likely drive Treasury yields higher and push out market expectation for additional Federal Reserve (Fed) rate cuts. Longer term, if the US dollar and Treasury yields begin to fall, it could suggest that tariffs are impacting demand and slowing the US economy.
Reciprocal tariffs are designed to mirror the level of tariff imposed on US goods imported into other countries. One potential reason for threatening to impose identical reciprocal tariffs is to force other countries to reduce their tariffs on imported US goods. If the strategy proves effective and tariffs on US imports are lowered, consumers in those countries will perceive US goods as less expensive. Assuming all else is equal, this could boost demand for these goods, thereby increasing US exports and reducing the US trade deficit, which might lead to a weakening of the US dollar. We would subsequently expect Treasury yields to fall and inflation pressure to ease, reflecting greater global competition, a flatter trade balance and more room for the Fed to lower rates.
As with first-mover tariffs, we believe that reciprocal tariffs may provide an indication of potential impact through the movement of the US dollar and Treasury yields. If the US dollar continues to strengthen as these tariffs are announced, it would suggest market participants believe higher tariffs will be the final outcome. However, if the dollar begins to weaken and yields decline, it suggests market participants believe countries will lower their trade barriers, increasing global trade.
Why are we watching Treasury yields?
We believe President Trump is focused on yields and is seeking alternative ways to lower interest rates given the weaker relationship between the federal funds rate and Treasury yields in this current cutting cycle. So far, 2024 rate cuts have had less of an impact on Treasury yields and the cost of borrowing for individuals and businesses than any other recent rate cutting cycle.
Source: Bloomberg LP and Columbia Threadneedle Investments, as of 31 January 2025
One way to lower the cost of debt (in this case Treasury yields), is to improve the creditworthiness of the underlying business (the US government). Recent headlines suggest that President Trump is attempting to do this by reducing the US budget deficit. In terms of spending, there’s an effort to cut costs by applying zero-based budgeting to the US government. In terms of revenue, there’s a focus on stimulating the economy by reducing the price of US goods abroad, thereby increasing US exports.
The bottom line
Tariff headlines are coming in quick and fast. In the case of first-mover tariffs, if we see a stronger US dollar and higher yields it could suggest higher inflation in the near term, a risk of long-term demand destruction, and a higher risk of a recession. In the case of reciprocal tariffs, if other countries retain their existing levels of tariffs on US imports and the US increases its tariffs in response, we expect similar outcomes as in the case of first-mover tariffs. However, if other countries lower their tariffs on US imports in response to the threat of reciprocal tariffs, we would expect a weaker dollar and lower yields, reflecting a reduction in the US deficit and an increase in global trade.
For investors, it’s important to focus on the impact these policies could have on the economy and the market. As active managers, we are closely monitoring the US dollar and Treasury yields, and leveraging our central research capabilities to proactively position portfolios ahead of these policy risks.
