Bond Traders Warn Of Inflation Shock As US Yield Curve Flattens

(Bloomberg) - US bond markets are flashing a warning to US President Donald Trump that his move to unleash tariffs on top trading partners risks fueling inflation and stymieing growth.

Short-end Treasury yields rose as much as eight basis points to 4.28% on Monday as longer-dated rates held steady, flattening the curve by the most since November.

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Such moves are typically associated with stagflation — when inflation and elevated interest rates harm bonds in the short term, only for subsequently weaker growth to make longer-term debt more appealing.

Traders have pared bets on the extent of easing from the Federal Reserve this year and now see a 50% chance of two quarter-point rate cuts this year, down from 90% on Friday.

Over the weekend, Trump followed through on his threat to impose levies on the exports of Canada, Mexico and China, while reiterating a warning to the European Union that tariffs “will definitely happen.” Goldman Sachs Group Inc. is positioning for further curve flattening, and firms including BNP Paribas SA, Singapore’s DBS Bank Ltd. and Japan’s SMBC Nikko Securities Inc. said this puts the US economy at risk of falling into stagflation.

“Trump’s policy mix has increased stagflationary risks in the economy,” Calvin Tse, head of Americas macro strategy and US economics at BNP in New York, wrote in a note. That implies the Fed will keep rates on hold for the next couple of meetings while it judges whether growth or inflation risks are “more serious,” Tse added.

With gasoline and food not excluded from tariffs, the BNP strategists said long-term inflation expectations could keep rising, favoring 10-year inflation-linked Treasuries.

“If this does indeed materialize, we think that rate hikes become a real possibility from the Fed this year, even in the face of lower growth,” they added.

Euro-area bonds diverged sharply with US peers, rallying amid a broad flight to safety. The two-year German yield dropped eight basis points to 2.05%, more than 220 basis points lower than the US equivalent, the wides gap since late December.

“In terms of the strategic implications of this dramatic opening salvo on the trade war front, we would be firmly biased in favor of a wider Atlantic spread,” Rabobank strategists wrote in a note. They recommend positioning for that move via shorter-dated tenors given longer-dated Treasuries may gain on the view that trade frictions will weigh on future US growth.

Goldman Sachs sees the Fed as more likely to hold rates steady to contain inflation risk than to cut them to boost growth.

“That more hawkish outcome ought to correspond to markets pricing more downside to growth/less upside to inflation further out, ultimately weighing on longer term yields and flattening the curve,” said Dominic Wilson, senior markets advisor at Goldman.

The Fed last week left policy unchanged as it waited for fresh progress on inflation following a string of rate reductions last year. Data on Friday showed that the central bank’s preferred measure of underlying inflation remained muted in December and that real disposable income barely rose.

Traders are also preparing for the first Treasury refunding announcement under the Trump administration on Wednesday.

By Ruth Carson
With assistance from Matthew Thomas and Neha D'silva

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