(Bloomberg) — Shell-shocked investors are piling into US Treasuries on concern that Donald Trump’s trade war will trigger a worldwide recession — ignoring for now, at least, the risk that the same punitive tariffs may unleash another bout of inflation.
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After a rally in US government debt that sent the two-year yield to touch the lowest since 2022, traders are positioning for more gains and pricing in a greater chance the Federal Reserve moves most aggressively to cut interest rates to keep the economy from stalling. While the bullishness may be warranted in the short term, AlphaSimplex Group’s Kathryn Kaminski says that investors fixated on slowing growth are ignoring Fed Chair Jerome Powell’s comments about the inflationary impact of tariffs at their own peril.
“The market is reacting strongly to the potential for weaker growth and demand destruction,” said Kaminski, AlphaSimplex’s chief strategist and portfolio manager. “This should put the Fed in a difficult situation where they would be likely to cut rates based on weaker growth, yet inflation could make that process more complicated. The market seems to be settling into more seeing the tariff news as very bad, and we see going long bonds now is the right call.”
Stagflation, a term that refers to a slowing economy coupled with elevated prices, stands to upend the bond market. Speaking Friday, Powell acknowledged that tariffs could make implementing policy difficult.
“While tariffs are highly likely to generate at least a temporary rise in inflation, it is also possible that the effects could be more persistent,” he said, reiterating the central bank is in no hurry to adjust rates.
Nevertheless, activity in futures contracts linked to Fed meetings into 2026 have moved from pricing in less than three cuts to nearly four by December. Other futures trades placed last week anticipate the central bank may only slowly move, an outcome that eventually leads to bigger reductions next year.
It’s the kind of positioning that shows Fed officials are in a tough spot, as they focus on a near-term inflation shock from tariffs being implemented. That was a point made by Morgan Stanley chief US economist Michael Gapen who pushed his call for the next rate cut from June to next year.
“The longer the Fed waits to cut, the more they will need to deliver in totality,” said Priya Misra, portfolio manager at JP Morgan Asset Management.
What Bloomberg Strategists Say…
“While acknowledging that tariffs look like they will be bigger than expected, [Powell] seems to focus more on the potential impact on inflation and inflation expectations than growth. Notably absent was any mention of financial markets or financial conditions; the strike price of the Fed put looks like it is still too distant to see.” — Cameron Crise, macro strategist, See more on MLIV.
Since Wednesday it’s clear that investors have been sheltering in bonds as they bet on a possible US recession. Policy sensitive Treasury yields at one point tumbled more than 0.4% after Trump unveiled US tariff rates for US trading partners.
That left the two-year yield trading near 3.5% — its lowest level since September 2022. Meanwhile, yields out to the 10 year briefly tumbled below 4% for the first time since October. Benchmark 10-year yields fell as much as 11 basis points in Asia Monday to 3.88%.
“We are in a period of extreme macro uncertainty,” said Daniel Ivascyn, group chief investment officer at Pacific Investment Management Co. “The very nature of this shock is different versus other shocks over the last few decades given that inflation is elevated and is likely to go higher.”
US consumer price inflation for March arrives Thursday. Annual measures are forecast to remain above the Fed’s target of 2% but that read won’t take into account the force of tariffs.
At the margins, some in markets are debating whether foreigners might even scale back Treasury purchases as a retaliatory strike. China and Japan are the largest overseas owners of US sovereign debt, with the former already trimming its Treasury stockpile for three straight years, while Japan’s has also dropped, based on the latest US government data.
Last week, US two-year Treasury inflation expectations surged to fresh peaks since 2022, and the Fed keenly focuses on these metrics to help guide their monetary policy decisions given they say they can drive movements in actual inflation. Powell back in 2019 went so far as to call inflation expectations “the most important driver of actual inflation.”
Typically, more weight is placed on longer-dated inflation expectations as they are seen excluding short-term noise. The Fed’s five-year forward inflation rate, one of its favored market metric of long run inflation expectations, sits around 2.3% — versus a peak this year of 2.47% in January.
“This is a very fluid situation and the outcomes are not engraved in stone, and that creates an incredible amount of volatility for markets ahead of us,” said Kevin Flanagan, head of fixed income strategy at Wisdom Tree. “For Treasury yields to continue to fall from here, you need to see the economy beginning to buckle. But on the other side of that, what will inflation be?”
What to Watch
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Economic data:
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April 7: Consumer credit
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April 8: NFIB small business optimism
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April 9: MBA mortgage applications; wholesale trade and inventories
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April 10: Consumer price index; initial jobless claims; Federal budget balance
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April 11: Producer price index; U. of Michigan sentiment and inflation expectations
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Fed calendar:
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April 7: Fed Governor Adriana Kugler
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April 8: San Francisco Fed President Mary Daly
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April 9: Richmond Fed President Tom Barkin; Federal Open Market Committee meeting minutes for March
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April 10: Dallas Fed President Lorie Logan; Chicago Fed President Austan Goolsbee; Philadelphia Fed President Patrick Harker; Fed Governor Michelle Bowman has Senate nomination hearing for the position of vice chair for supervision
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April 11: St. Louis Fed President Alberto Musalem; New York Fed President John Williams
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Auction calendar:
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April 7: 13-, 26-week bills; 14-day cash management bills
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April 8: 6-week bills; three-year notes
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April 9: 17-week bills; 10-year notes
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April 10: 4-, 8-week bills; 30-year bonds
(Updates with 10-year yield trading)
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