Rates Spark: The ante is upped on tariffs - now what?

As the US imposed tariffs on several countries, including Japan and South Korea, of between 25% to 40%, the realisation dawns that a ratchet-up phase is indeed upon us. From the markets perspective, no dramatic reaction so far. Things change so often that a conviction reaction seems less likely on these announcements. Since they are being done just a few at a time tends to reduce their significance. Also, it seems like the market is choosing not to pre-suppose bad-case outcomes. Instead preferring to wait and see what actually happens. Hence the relatively mild reaction, so far. Also the market should be assuming rises in tariffs for most countries, as that's the most likely outcome. Remarkable really how well the market is taking all of this.

That said, the test now is whether, 1. We go risk-off as equity markets discount a negative outcome, and/or 2. Whether Treasuries get sold, and basically, 3. Whether we resume where we left off on 9 April. And if it turns sour, and it could, then the US 10yr yield gets back up to 4.6% (9 April high just before the 'pause'). But this time keeps on rising. And the 10yr swap spread gets back out to 65bp, and also keeps on rising. The fiscal and inflation back stories are pushing in the same direction.

Trade is the main focus this week with little in terms of data on the agenda and markets seem to have started the week with constructive risk sentiment. The US government had said any new tariffs would kick in from 1 August, which suggests more time to negotiate deals beyond the original 9 July deadline. Eurozone risk assets appreciate the flexibility with equities moving a touch higher whilst implied volatility measures suggest a relatively sanguine outlook.

In rates markets the positive trade news is being translated into more steepening pressures. The 10y EUR swap rate headed above 2.6% again. We think more clarity around trade is a prerequisite for rates to drift higher as it allows markets to focus more on the EU and German spending stories. Short-end rates will remain more under wraps as the ECB is now increasingly voicing concerns about undershooting its inflation target against the backdrop of the stronger EUR and generally easing tensions in energy markets despite the recent incident in the Red Sea.

Whilst we see room for longer-dated EUR rates to drift higher upon the signing of a trade deal, the initial market reaction may be limited. The 5y5y real rate in the chart below shows that markets have remained positioned for an improved long-term economic outlook ever since the German spending announcements. Trump’s trade tantrum thereafter did little to move that pricing. A trade deal should therefore not necessarily warrant an immediate repricing of the back end of the curve.

The transition towards higher rates on the back of the EU spending ambitions will take time, also because investors may remain sceptical about the form and pace of implementation. In any case, the spending plans should reduce the chance of returning to a world of secular stagnation, one in which inflation and policy rates are forced close to zero. So even though we don’t pencil in stellar growth numbers on the back of the fiscal expansion, we do think the 10Y swap rate can continue to drift higher.

The added bond supply should also push up rates from the back end, a theme we have seen develop in many markets of late. Both in the UK and Japan we see the 30Y government bond yields under strong upward pressure on the back of fiscal concerns. Whilst Germany is in a much better position, we can expect Bunds yields to feel increased upward pressure in the coming years, especially versus swaps. A larger term premium in US Treasury markets due to the increasing deficit can also bring spillovers to global curves.