Passionate, insightful, contrarian at times and always a true thought-leader in his field, Mark Dowding shares fresh fixed income insights every Friday. His musings on the week cover macro developments, bond market trends and his latest positioning thoughts, with the odd joke thrown in for good measure.
Trump imposes tariffs on Canada and Mexico, and increases tariffs on Chinese imports by 10%, causing US market jitters.
Tariffs are expected to impact inflation significantly, and it is likely that Fed rate cuts will be hindered in the months ahead.
Incoming German Chancellor Merz's fiscal policy changes could boost EU defence and infrastructure spending, resulting in increased GDP.
We see a firmer outlook for the the euro's outlook due to the EU/US growth rate, interest rate differentials, and negative sentiment towards the US.
Rising anti-Trump sentiment is helping to shore up support for Mark Carney, making the Canadian election outcome less certain than before.
With Trump moving ahead with tariffs on Canada and Mexico, plus an additional 10% on Chinese imports, US markets have been unsettled by the potential economic implications of these moves. There has been some focus that trade policy will weigh on US growth and this has seen Treasury yields rally.
However, we are more inclined to think that the tariff impact on inflation will be as, or more significant, than the growth impact. With the CPI likely to push higher, we think that it will be difficult for the Federal Reserve to cut rates in the months ahead. Consequently, with markets discounting more than 75bps of easing this year, we have seen an opportunity to move to a short duration stance.
Meanwhile, a fiscal U-turn by incoming German Chancellor Merz has set the stage for a substantial increase in spending on defence and infrastructure, in a move we expect to see replicated across the EU. By excluding defence spending above 1% of GDP from Germany’s ‘black zero’ rules on the fiscal deficit, Merz has been able to echo the words of Mario Draghi, in claiming he was in a position to do ‘whatever it takes’ to ensure Germany’s security.
Total German spending on defence and infrastructure could total close to EUR1 trillion in the coming decade, lifting German defence outlays to the same level as the US, on a percentage of GDP basis. With these moves replicated across the EU, this can be expected to raise GDP by 0.7% per annum on our estimates, taking annual GDP up from around 0.8% last year to 1.5%, or thereabouts. Similarly, we might expect Eurozone inflation to settle around 2.5%, somewhat above the ECB price objective.
This being the case, we feel that this week’s ECB rate cut from 2.75% to 2.50% could end up as the last in this cycle. In light of this, we saw an opportunity to take a short rate stance in Euribor futures, which discounted Eurozone cash rates hitting 2% by the end of the year. This forecast revision also means that we are more wary of running short euro positions in FX.
We have previously maintained a relatively downbeat view on the currency through the back end of 2024 and coming into 2025. However, the case to be bearish euro is no longer merited. On the one hand, we continue to be concerned about a potential tariff impact in Europe, given how dependent the economy has been on exports.
Yet a narrowing of the EU/US growth rate and interest rate differential speaks to a firmer outlook for the single currency. Meanwhile, growing global disdain towards the US may drive asset allocation shifts away from US dollar assets. In this respect, it was notable to see the Norwegian sovereign wealth fund speak of selling its US assets this week, in order to assist in the development of the European defence industry.
Additional mutualisation of debt in the Eurozone also represents some additional integration within the bloc, which can be net beneficial for spreads. Although higher nominal yields can be a worry for sovereign credits such as Italy, we remain structurally inclined to see BTP spreads rally close to French OATs during the course of this year, echoing the France/Spain convergence trade last year. With respect to bunds, we think that if Eurozone cash rates settle around 2.5%, then 3% bund yields may represent longer-term fair value.
The UK has been out of the limelight over the past week. We continue to be concerned at the inflationary backdrop and the lack of fiscal space in the UK. As gilt yields are dragged higher by bund yields, the risk is that higher funding costs feed back into projections around UK debt. At least Starmer can feel a bit more hopeful that he seems to be avoiding the ire of Trump and the US trade hawks when it comes to tariffs.
By contrast, Canada is experiencing the full force of the US President’s personal disdain for Prime Minister Trudeau. Not only does Trump seem delighted in himself, by baiting Trudeau as the Governor of the 51st state, he has also taken satisfaction that Canadian society has long fallen out of love with its Premier.
That said, a rising anti-Trump sentiment is now helping to shore up support for Mark Carney, making the Canadian election outcome less certain than before. However, this means in the short term, Canadian politicians are more likely to be combative than conciliatory towards Trump, which could lead to further mudslinging and tariff escalation. This may prompt material downside risk for the Canadian economy.
Fortunately, however, it may seem that weaker US equity prices may force a moderation in US rhetoric. In this context, we are confident on a medium-term view, that all interests are best served by a strong and productive relationship between the two neighbours. This being the case, we think that eventually we may settle with tariffs at a more manageable 10% rate, in the weeks or months ahead.
In Japan, focus has been given to Trump’s comments, noting his concern at the undervaluation of the yen on the back of real interest rates, which are too low and have depressed the currency’s valuation. This has been a factor leading to ongoing upward revisions in Japanese rate forecasts, which have seen JGB yields continue to move higher, just as US yields have moved in the opposite direction. 10-year rates now stand at their highest level for 16 years, just above 1.50%.
We think that yields should now stabilise in a range between 1.5% and 1.75%, so have determined that it is appropriate to close our long-held short position on JGBs. Meanwhile, we continue to favour the yen to outperform over the coming months. The Japanese currency has been edging stronger over the past two months, but we still feel we are only at the start of this particular trend.
Credit spreads have continued to follow macro moves over the past week. In this regard, Eurozone corporates have been outperforming their US peers on spreads since the start of the year, with sectors such as euro financials as standout performers. We have remained content to sell exposure on strength, but have simultaneously been lifting credit hedges, so that overall credit beta exposure remains broadly in-line with the index.
Meanwhile, Eurozone swap spreads have been moving tighter as bunds cheapen on a relative basis versus other Eurozone fixed income assets, adjusting to increased potential for supply. Nevertheless, we feel that swap valuations are rich, and we would note that German debt levels are coming from a starting point where debt-to-GDP is very low and the country has ample fiscal space. On that basis, this relative valuation may have already moved further than is fundamentally warranted.
Looking ahead
US payrolls data is incoming later today, with CPI to follow next week. We are biased to think that hard economic data should remain relatively robust. However, investors will be focussed on any signs that growth is slowing, and this could represent a challenge to risk assets.
That said, there is a growing sense that Trump will operate something of an S&P put, given that we think he will have a low tolerance for falling stock prices. Indeed, it was interesting to see how keen the administration has been to support the fortunes of the tech bros, by announcing the creation of a crypto strategic reserve, which will contain a number of smaller coins, in addition to bitcoin and ethereum.
Given the unregulated nature of these markets, it may seem that there is plenty of scope for market abuse in this space. When it comes to the stock market, it could be argued that this may be something that holds Trump accountable more than any other body or world leader. In this way, it is interesting to see how he may modify his actions and behaviour should equity prices start to slide further.
It seems crazy to think that Trump has only been back in the White House for six weeks, given how much change seems to have occurred in the period since. With Trump declaring this week that he is ‘only just getting started’ there is a sense that we are living in a new normal. Sometimes it feels like watching a player who has walked up to a pool table and whacked a load of balls as hard as possible, not knowing where they will go, or which ones may fall into a pocket. For sure, Trump revels in chaos and Musk delights in the Schumpeterian school of ‘creative destruction’.
Yet it will be interesting to observe some of the unintended consequences of US policy actions. For example, Trump has long sought to weaken the EU as an institution – yet in causing Germany to loosen its fiscal purse strings, we may yet come to see that the impact of Trump has played its part in Making Europe Great Again (though happily not in the mould of Musk and the far-right parties he has supported across the continent). Indeed, it seems that MEGA trades are now rapidly replacing MAGA trades, which have lost their appeal.