Rising Risk of Trade War, but Yields Down – Why? — Evening Brief – 02.06.25

Notwithstanding volatility from tariffs and executive orders, the U.S. Treasury market has exhibited a degree of stability. While this may change, government bond yields have predominantly remained steady or experienced minor declines over the past week, with the U.S. 10-year yield down nine basis points so far and down about 45 basis points over the past three weeks. The policy-sensitive U.S. 2-year yield is also moving lower, falling to 4.21% on Thursday, well below its three-week peak of about 4.40%.

The calm demeanor of U.S. Treasury yields is somewhat surprising, especially considering the constant stream of news on issues that should, in theory, influence market expectations, inflation, and economic growth. This week, President Trump initiated a trade war but then eased some of the tension by potentially temporarily halting plans to impose 25% tariffs on Canada and Mexico, although the new 10% tariff on China imports remains in place.

One concern is that tariffs could drive up prices, leading to inflation. Optimists argue that any inflationary increase from tariffs would likely be short-term. However, stronger pricing pressures could be problematic, especially as the Federal Reserve is still working to fully address the inflation surge caused by the pandemic. The timing is tricky, as the Fed is trying to complete its efforts to stabilize inflation, and any new inflationary forces could complicate that process.

A prevailing notion under consideration is that the Federal Reserve may undertake preemptive measures should it foresee the potential for a global trade war to incite a resurgence of inflationary pressures. Nevertheless, Mary Daly, President of the San Francisco Fed, minimized the probability of an early tightening, indicating the central bank may refrain from taking prompt action in response to potential inflationary risks arising from trade tensions.

The Fed does not “need to be pre-emptive at this point,” Daly told The New York Times on Monday. “We have policy calibrated for this economy and the one we expect to have, and we’ve got time now to be actively watching to see what else is done.”

For the time being, the U.S. Treasury market seems to be looking past the headlines, signaling that a disinflationary trend is still in play. This suggests that despite the ongoing news around tariffs and potential inflationary pressures, Treasury yields remain relatively stable, reflecting expectations that inflation will remain under control in the near term.

The recent decline in U.S. Treasury yields may be also driven by the view that a trade war could lead to slower economic growth, or even worse, an economic downturn.

In this context, demand for safe-haven Treasuries could outweigh concerns about higher inflation. Investors might be prioritizing the security and stability of government bonds over inflation risks, reflecting a more cautious outlook on the global economy amid trade tensions.