The month of April demonstrated the complexity of capital market relationships. After a solid first quarter, where US Treasuries offered some positive returns to counter struggling stocks, the volatility shock created by the 2 April ‘Liberation Day’ announcement and President Donald Trump’s later attack on Federal Reserve (Fed) chair Jerome Powell temporarily took things in another direction. The unusual confluence of a falling US dollar, falling stock prices, and suddenly rising long-term US Treasury yields generated concerns of a ‘sell the US’ reaction.
In order to understand how the tariffs announcement shocked markets, it’s important to consider that the opposite of the trade deficit – which comprises most of the current account – is the capital account surplus, representing the flow of foreign capital into US financial assets. During April, several questions arose simultaneously. Did President Trump’s higher-than-expected proposed tariffs (which are aimed at shrinking the trade deficit) prompt some immediate reallocation of capital account flows away from the US? Did the interest rate volatility shock intensify because of a rapid, painful unwind of leveraged relative-value trades in US rates markets? Did Trump’s threats to fire the Fed chair further erode confidence in US financial markets? It seems each of these factors contributed, to some degree, to the surprising Treasury market performance during parts of April.
Ultimately, the bond market stress helped prompt the Trump administration to delay the full implementation of reciprocal tariffs, allowing for a period of negotiations. In addition, market stress helped quiet, if not end, the White House attacks on Powell. Treasury market stress has since eased and yields have fallen from their April peaks, allowing investors to refocus on growth expectations, federal budget deliberations and the Fed.
Did Trump’s threats to fire the Fed chair further erode confidence in US financial markets?
On the growth front, April ended with an unexpected negative Q1 US GDP print arising from a massive import surge to front-run the tariffs. The growth-dampening effect of tariffs likely will broaden further as the high level of uncertainty around trade policy will mute hiring and corporate capital expenditures in coming quarters. While the inflation effect of tariffs could be short lived, it will still represent a negative cost-of-living shock to consumers and a profit squeeze to many companies. Consensus GDP growth forecasts for coming quarters have fallen well below 1.0%, and the risk of more negative GDP prints has risen.
Regarding the budget, the planned massive reconciliation bill outlined in separate House and Senate budget resolutions now takes centre stage. The broad plan provides for a debt ceiling increase and a large expansion in the deficit over 10 years, estimated at above US$5trn, assuming no spending cuts or tariffs revenue offsets. Of course, some combination of both will enter the picture, but so too could the additional tax cuts that President Trump campaigned upon. The Trump administration likely will favour some net stimulus beyond simply extending the expiring tax provisions. Overall, borrowing needs likely will rise in coming years.
As for the Fed, against a background of verbal cannon fire from the White House, monetary policy remains in a tough spot. Powell has suggested that a tariff-induced boost to prices and contraction to growth will leave the Fed in no hurry to ease rates as it remains data dependent. Recently, however, some of his Federal Open Market Committee (FOMC) colleagues are suggesting a subtle shift toward easing policy should the employment side of the dual mandate weaken while long-term inflation expectations remain stable. The market has priced in almost 100 bps of eases this calendar year. That may be excessive, but likely weakness in employment growth in coming months should prompt the Fed to resume their easing path.
Looking outside of the US, tariffs have challenged the global growth outlook. From China to broader emerging markets to the eurozone, growth expectations have faded, and several central banks have lowered interest rates.
All told, this complicated picture remains supportive of maintaining at least a neutral duration position in fixed income portfolios relative to the benchmark. The Duration pod continues to anticipate weakening fundamentals in the US and abroad and will look for spots to take a long position.
After all the April volatility, it is comforting to note the US Treasury index posted a total return of +0.63% for the month. A small return, yes, but in the ‘right’ direction amid the slowing economy and risk asset volatility.
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