Refining tariff thoughts
For a big-picture take on recent U.S. policy shocks and market volatility from our Chief Investment Officer, Dan Chornous, refer here: Navigating volatility in the wake of U.S. policy shocks.
Tariff developments
It feels impossible that reciprocal tariffs were first announced less than a month ago. Surely months have passed since then! But no, it just feels that way.
Since the last MacroMemo, published on April 8, a large chunk of the reciprocal tariffs have been delayed by 90 days – to great fanfare – with “just” a 10% baseline portion left in place. Conversely, U.S. tariffs on China were ratcheted higher to as much as 245% by the end of April, with China broadly retaliating.
Direction of travel in recent weeks
As much as there has been an ebb and flow of tariffs, the direction of travel in recent weeks has been distinctly toward fewer tariffs. The constructive tariff developments include the following:
The 90-day delay on a large fraction of the reciprocal tariffs.
Carveouts from Chinese tariffs that exempt critical imports into the U.S. such as electronics.
Rumours that there could be certain carveouts coming for previously implemented auto tariffs.
Favourable talk from the White House about the prospect of a trade deal with China, including that tariffs on China will “come down substantially”, that Trump won’t “play hardball” and that he plans to be “very nice” to China. (China, for its part, seems less inclined to negotiate.)
As such, it would appear that the White House has blinked, signaling the limits of its willingness to tolerate economic and financial market pain resulting from tariffs. This is a critical development, as it argues that giant tariffs are unlikely to be applied, or to persist indefinitely.
China-U.S. balance of tariff power
The main thrust of the trade war currently underway is being waged between two economic behemoths: the U.S. and China. While the U.S. has certain advantages, including a bigger economy and enormous influence over the global financial system, it is on the whole the more vulnerable of the two economies.
An asymmetry that clearly favours China is that the U.S is levying tariffs on nearly all of its trading partners, whereas China is only at odds with the U.S. Thus, the overall trade damage stands to be greater for the U.S. than for China.
Admittedly, the calculus is tricky. It is undeniable that China sells more products to the U.S. than the U.S. sells to China, so any interruption to this trade does more direct damage to Chinese value-added than to the U.S.
But this misses the other side of the equation, which is that U.S. consumers and U.S. businesses are therefore even more reliant on Chinese inputs than their Chinese counterparts are on U.S. inputs. It takes two to tango when it comes to trade, with both parties benefiting. Both parties therefore suffer when that trade is disrupted, even if the U.S. pain is of a second-order nature as households and businesses go without certain critical inputs.
An asymmetry that clearly favours China is that the U.S is levying tariffs on nearly all of its trading partners, whereas China is only at odds with the U.S. Thus, the overall trade damage stands to be greater for the U.S. than for China.
As an addendum, China’s GDP (gross domestic product) exposure to the U.S. is fairly small. The conventional estimate that 2.4% of what China makes is purchased by Americans is too low. It misses transshipments through other countries and the shipment of goods that have historically benefitted from the U.S. de minimis exemption. But even after factoring all of that in, China still only relies on the U.S. to buy about 3.4% of what the country makes (see next chart).
China’s GDP has low exposure to U.S. through global trade
Another asymmetry that favours China exists at the sector level. In a stylized sense, U.S. exports skew toward substitutable commodities such as agricultural products. China, on the other hand, tends to sell differentiated manufactured goods such as electronics. The consequence of this is that it is relatively easier for China to find other purveyors of those commodities on the international market, whereas there is no real alternative in the short run for the U.S. if it seeks to diversify away from Chinese manufactured goods. These include solar panels, batteries, phones, computers, monitors, gaming consoles and so on.
At a (much!) more granular level, over 99% of U.S. electric toasters, heated blankets and alarm clocks come from China. So do over 90% of LED lamps and folding umbrellas, along with a myriad of other goods.
Another way of quantifying this asymmetry is that for 36% of the products the U.S. buys from China, it relies on China for over 70% of its supply of that product. In contrast, only 10% of the products that China buys from the U.S. come primarily (>70%) from the U.S. That list includes aircraft, for which there would appear to be the ability to pivot from Boeing to Airbus – as evidenced by China’s recent decision to stop accepting deliveries of Boeing orders. On the whole, the consequences of losing access to the other country is therefore much greater for the U.S.
The conclusion is not that China wins any trade war with the U.S., but that China might lose by less.
China also possesses trade leverage in its dominance of the rare earths industry, and of a range of critical minerals. The country also owns approximately US$761 in U.S. Treasuries and several hundred billion dollars of mortgage-backed securities, which could damage the U.S. bond market if sold.
China also has the benefit of being able to take the long view, in large part due to its political structure, but also due to its long history, the compliance and tolerance of economic hardship of its citizens, and its system of supports for key industries that could help to keep them viable during a trade war.
The conclusion is not that China wins any trade war with the U.S., but that China might lose by less. China also has the possibility of strengthening its international influence as the U.S. steps back from its traditional international roles.
To some extent, the binary choice for the rest of the world is whether to join Team USA or Team China. The U.S. is expected to insist that countries limit their exposure to China as part of trade negotiations, and China has threatened to levy tariffs on countries that agree to do that. Countries will attempt to dance around this choice, preferring to retain access to both markets. This debate will be especially fraught for Asian nations that are heavily trade-oriented and quite geared toward both China and the U.S. It is unclear how severed the two spheres of influence will truly become.
Still pain to come
Despite a general trend toward fewer tariffs, there are still several pre-announced tariffs on their way and considerable lagged economic pain still coming.
Trade policy uncertainty may now be declining – a welcome sign. But it is still very high and has already been theoretically doing economic damage for several months as businesses and households shy away from major decisions (see next chart).
Global trade policy uncertainty remains high despite 90-day pause on country-specific reciprocal tariffs
The White House has threatened additional sector-oriented tariffs on computer chips, forestry products, pharmaceuticals and copper. The Commerce Department also plans to impose tariffs of up to 3,521% on solar panel imports from a handful of developing Asian nations.
The American US$800 de minimis import exemption on low-value goods is about to expire for Chinese products on May 2, affecting tens of billions of dollars of imports per year.
Auto parts tariffs are supposed to take effect on May 3, lagging their twin – tariffs on completed motor vehicles – by a month.
The 90-day delay of reciprocal tariffs is just that – a delay – and some fraction will presumably reassert itself in July.
Most of the economic pain associated with tariffs does not immediately appear. This is due to a mix of factors.
USMCA renegotiations between the U.S., Canada and Mexico will also presumably come into view at some point over the next few quarters, with the very real prospect of tariffs or at least tariff threats levelled as an inducement for Canada and Mexico to fall into line.
Most of the economic pain associated with tariffs does not immediately appear. This is due to a mix of factors, including:
front-loading (more on that shortly)
shipping time (it takes about 8 weeks for a product to transit from Chinese factors to U.S. retail shelves)
inventory considerations (depending on the industry, it can take a few months to exhaust the supply of cheap pre-tariff products)
the existence of some fixed-price contracts that also take time to expire.
What is clear is that shipping from China to the U.S. has fallen sharply, by between 30−50% in the latest data relative to the volume achieved a year earlier. That might exaggerate the impact as those same shipping lines and ports pumped through an unusually large number of goods over the weeks before tariffs took full effect, leaving less need to ship now. Companies are presumably also hoping that some part of the China tariffs decline, allowing them to catch up later. But the point is that the damage should be very real and start to become visible in the May and June economic data.
Front-loading ahead of tariffs
There are signs that heightened policy uncertainty is weighing on demand. But that dynamic will be partially offset by front-loading of activity as importers, wholesalers, retailers and consumers seek to get ahead of impending tariffs and potential price hikes.
Significant cross-border integration in the auto sector has made it the posterchild for potential tariff-driven price increases, with automakers warning that import levies could add thousands of dollars to new vehicle prices. Auto sales jumped 13% year-over-year in March as consumers aimed to lock in pre-tariff pricing. According to the Fed’s Beige Book, “most Districts saw moderate to robust sales of vehicles and of some nondurables, generally attributed to a rush to purchase ahead of tariff-related price increases.”
Front-loading is showing up in trade data as well. Imports of consumer goods into the U.S. jumped by 25% year-over-year in February (see next chart). Countries like China and Taiwan saw a surge in exports. The latest ISM (Institute for Supply Management) Manufacturing survey attributed growing U.S. imports to buyers getting ahead of tariffs by bringing forward future deliveries. Inventories are also expanding as companies pull forward purchases of materials to minimize the financial hit from tariffs.
U.S. consumer goods imports surged ahead of tariffs
Recent corporate earnings calls made references to front-loading across a variety of sectors including consumer goods, industrials, pharmaceuticals, technology and financials. Costco, for instance, noted higher supply chain costs in its second quarter as it stocked up on inventories amid potential tariff risks. 3M said its first-quarter growth was led by China as key accounts increased orders ahead of tariffs. Several industrial companies also mentioned pre-buying to navigate potential tariff impacts and financial firms said their clients were drawing down lines of credit to fund higher inventory levels.
Fortunately, supply chains appear to be managing this increase in activity with relative ease. There are few signs of the severe strains that characterized the pandemic. The New York Federal Reserve’s supply chain stress index continued to indicate normal conditions through March (see next chart). Global shipping costs, including routes from China to the U.S., don’t appear to reflect a surge in demand. And a modest increase in freight demand and trucking prices earlier this year appears to be tapering off.
Global supply chains are showing few signs of strain
This pull-forward of economic activity could flatter near-term growth figures to the extent that production is being temporarily ramped up. But slower growth is likely to follow as businesses begin to draw down inventories, and pre-purchases by consumers and businesses give way to a demand air pocket. The ISM Manufacturing report showed that after a jump at the start of the year, new orders are now declining. The gap between growing inventories and shrinking new orders – a key indicator of the health of the manufacturing sector – is now at its worst level since the pandemic.
Front-loading imports could delay the inflationary response to tariffs until sellers work through inventories at pre-tariff prices. Consistent with this, daily consumer price data is only starting to show a small effect from higher import prices, even though U.S. customs receipts surged by 44% year-over-year as of April 24. Of course, some of that increase in duties paid could be due to front-loading. We’ll need to see actual trade volumes to get a better sense of the extent to which higher effective tariff rates are driving the increase in customs receipts.
Negotiations pending
Negotiations between the U.S. and its trade counterparts are set to be demanding, for several reasons.
A key problem is simply the matter of throughput. How can more than 180 countries and territories hope to negotiate with the U.S. all at once, and with a deadline that is now just over two months away? It took the U.S. 14 months to strike a deal with just Canada and Mexico in President Trump’s first term. Even with the best of intentions, this will be nearly impossible to accomplish.
In a positive scenario, the reciprocal tariffs are simply delayed further. In a negative scenario, those tariffs could hit, doing real damage.
Even more problematic is that there is zero clarity over what the U.S. actually wants out of tariff negotiations. Yes, it desires a smaller U.S. trade deficit. But achieved in what way? Based on initial overtures, it is seemingly not enough just to offer to remove one’s own tariff barriers. The fact that U.S. demands vary so much from week to week, and that in some cases they have never been coherently articulated, suggests it will come down to the whim of President Trump.
It is also unclear with whom countries should be seeking to negotiate. The Treasury Department? The Commerce Department? The White House directly? Furthermore, regardless of the answer to that question, Congress must eventually approve any new trade deal unless the contours of the agreement simply revert back to the pre-Trump scaffolding.
Possible first-moving countries to watch include Japan, South Korea, India and Vietnam. China, in contrast, appears content to let the U.S. dangle, though U.S. interest in a deal with China could nevertheless yield a resolution sooner than for countries further down the priority list. Japan, South Korea and India all appear open to committing to such concessions as purchasing additional U.S. energy and agricultural products.
Watching Vietnam
Vietnam, in particular, merits close attention as a potential bellwether for tariff negotiations. This is because it sits at the intersection of having an enormous economic exposure to the U.S. More than 25% of Vietnamese economic output is directed toward the U.S.. and Vietnam has one of the highest reciprocal tariff rates (46%).
Vietnam is a top source for U.S. imports of textiles, furniture and electronics. It gained particular traction as a manufacturing alternative after China was disadvantaged by tariffs in President Trump’s first term. Over 60% of Samsung’s global phone output comes from Vietnam. The country is also a top producer of such brands as Nike, Adidas and Lululemon. Some Japanese carmakers including Toyota, Honda and Mazda are also beginning to leverage the country’s growing industrial might.
Vietnam’s tariff vulnerability has naturally motivated the country to be especially proactive in seeking negotiations with the U.S. Vietnam’s General Secretary spoke with President Trump just two days after the reciprocal tariffs were announced and the country offered to eliminate all tariffs on U.S. imports. It is also working on cracking down on Chinese goods being rerouted through the country and on to the U.S. Vietnam is also said to be preparing a negotiation team for discussions with the U.S.
Vietnam is also fascinating because it is so closely connected to China. In fact, President Xi recently visited Vietnam and the two countries signed 45 cooperation agreements. It will thus be a real test for how well a country can straddle two spheres of influence.
As soon as the U.S. strikes a deal with a single country, we will gain a critical roadmap to understand White House priorities and the potential path forward for all of the other countries.
Corporate-level focus?
While tariffs can take the U.S. some distance toward the White House goal of a revitalized industrial base, they are imperfectly suited to the task.
The problem with tariffs is that, from a timing perspective, they inflict immediate pain whereas it is not possible for most industries – even in an absolute best-case scenario – to onshore in less than several years, if not much longer. Factories need to be built, workers trained, supply chains created and so on. Meanwhile, the American consumer and importers suffer for years under tariffs before that made-in-the-USA solutions exists.
For a second-term president, a multi-year trajectory toward onshoring is problematic. Much of the action comes after the president’s term has concluded, at which point policy priorities may shift under the next leader.
In this context, a more practical approach is arguably to exert acute political pressure at the sector- and individual corporation-level, demanding that businesses commit to large onshoring expenditures in the U.S. Some such promises are already being made, with tech companies in particular committing to hundreds of billions of dollars of additional spending.
The point is not that tariffs will be supplanted by a corporate-level focus, but that smaller tariffs paired with greater corporate-level pressure may be a direction this administration eventually takes.
The focus may logically shift toward manufacturing sectors, with pressure not just to promise investments but to put shovels into dirt and ensure that sufficient progress is being made during Trump’s term that there is reasonable confidence that the investment will continue into subsequent terms. The auto sector will be a key test. Pre-existing U.S. protectionism renders it a more realistic and high-value objective than many other sectors.
The point is not that tariffs will be supplanted by a corporate-level focus, but that smaller tariffs paired with greater corporate-level pressure may be a direction this administration eventually takes.
Base-case tariff assumptions
Our base-case tariff assumptions have not changed drastically over the past several weeks. However, we now articulate them with slightly more confidence given evidence of an inclination toward slightly smaller tariffs over the intervening period.
We still presume tariffs on China remain large, though more on the order of something like a 50% tariff endpoint than the current 245% maximum tariff.
For other countries, tariff rates in the 10-15% range are likely to prevail – the 10% baseline tariffs plus a handful of sector-level tariffs. But we do not expect the full reciprocal tariffs to be implemented for long.
Our calculations argue that this scenario doesn’t have to result in a recession for the U.S. or other countries, though there is always uncertainty around such prognostications.
These tariff views may be incrementally more optimistic than the market consensus, though not enormously so.
Our calculations argue that this scenario doesn’t have to result in a recession for the U.S. or other countries, though there is always uncertainty around such prognostications. The current working GDP growth forecasts for 2025 and 2026 are as follows (see next chart).
RBC GAM GDP forecast for developed markets
The risk of a recession is undeniably higher with tariffs than without: we target a 40% recession risk for the U.S. over the next year.
Worse tariff damage per unit of tariff?
While we think tariffs could arrive a hair lighter than the consensus, the problems is that tariffs could do more economic damage per unit of tariff than commonly supposed. This largely offsets that benefit.
Not only must one grapple with the direct effect of higher import prices reducing real incomes and trade barriers lowering productivity, but also with damage from high uncertainty, boycotting and supply chain distortions. Further, the present starting point is imperfect. Fiscal deficits are large (limiting fiscal stimulus as a response) and inflation is too high (limiting monetary stimulus as a response).
Evidence of boycotting is becoming visible via what is now a substantial 25% year-over-year (YoY) reduction in border crossings into the U.S. from Canada (see next chart).
Number of people entering the U.S. from Canada fell recently
We also posit that the econometric models attempting to tease out the economic implications of tariffs could be underestimating the direct damage. Put simply, these models have been calibrated using the past several decades of data, which have mostly been confined to small tariffs inching higher and lower.
It seems likely that a 20% tariff would be more than 10 times as damaging as a 2% tariff. The 2% tariff would be barely perceptible and likely elicit only a minimal supply and demand response. By contrast, a big tariff can completely up-end a market and economy. This non-linearity is not fully captured in conventional models.
From a financial market perspective, the normal multiplier between a hit to real GDP and the equivalent hit to corporate earnings is in the realm of two to three times. Thus, the expected 1 to 2 percentage point hit to U.S. GDP might subtract 2-6 percentage points from corporate earnings growth.
But given that tariffs have their primary effect on trade and given that publicly traded companies are the primary purveyor of traded goods, it is not unreasonable to argue that the corporate earnings multiplier in this situation might be more like two to six times real GDP. Using that rough multiplier, corporate earnings might lose 2-12 percentage points from corporate earnings growth instead.
It is some consolation that supply chain problems, while still likely in some form, can probably avoid the extremes of 2020−2023 since the dominant tariff implication is that demand for goods and especially for traded goods should decline. As a result, ports, warehouses and shipping should experience a significantly reduced volume that is only partially offset by logjams related to shifting preferences between goods and new sourcing patterns for certain products.
Downgrading the ex-U.S. inflation shock
Tariffs are inflationary. They constitute a tax on imports that is passed in significant part onto consumers in the form of higher prices. A recent Wolfe Research poll of consumer-facing companies confirms this, finding that 75% plan to pass most or all of their cost increases onto customers. Another 22% anticipate passing some portion along.
The tentative beginning of tariff-related inflation may be starting to come into view via real-time inflation data (see the blue line on the next chart). The series argues April prices may rise at the fastest pace in more than a year, and this despite the fact that gasoline prices were falling that month.
U.S. Daily PriceStats Inflation Index suggests inflation rising from tariffs
For all of that – and despite the very real inflation consequences for the U.S., which has levied the majority of tariffs – we have actually just downgraded the expected inflation effect for other markets. This diminished inflation impact ex-U.S. is for three reasons:
Other countries have not been responding to U.S. tariffs as forcefully as we had initially expected. The growth-damaging part of a tariff hits both the instigator and the target, but the inflation portion only hits the instigator, which increases its own prices by raising import costs. Thus, a more muted retaliation from other countries means a more muted inflation impact for those other countries. So far, most countries have done virtually nothing in response to U.S. tariffs, but we still think some partial response will occur once U.S. tariffs have stabilized. But the point is that the inflationary effect should be relatively smaller for most countries than for the U.S., even if one holds constant the economic impact.
The fact that economies weaken due to tariffs should mean that there is at least a mild deflationary force at play via a higher unemployment rate and other sources of economic slack. That’s as true for the U.S. as any other market but should be more visible in the countries not responding to tariffs in full tit-for-tat fashion.
As the U.S. shutters its borders to commerce, the rest of the world will find itself with a glut of certain products. One might imagine countries dumping these excess goods on one another, lowering prices. One estimate argues that European prices could be as much as half a percentage point lower than otherwise due to this channel.
We accept that dumping effects may prove a relevant force but do keep in mind a few tempering thoughts. One is that Chinese products tend to be differentiated goods. The involved companies are not necessarily competing as fiercely with one another on a price basis as in some sectors. Consequently, they may have more discipline than imagined, opting to reduce production and thereby maintain pricing.
Another consideration – of even greater relevance – is that whereas some sectors may experience gluts, others will experience shortages as U.S. products fail to reach international markets. The international producers in these sectors will be in a position to raise prices by more than otherwise, providing a theoretical offset to the dumping elsewhere.
On balance, there should be a bit more dumping than price-hiking given that the U.S. imports more than it exports. But any deflation from dumping should be relatively mild.
Still, the net effect is that international inflation shouldn’t experience quite the same jump as in the U.S.
Here is an illustrative calculation. A 20% tariff that would do 1.8% damage to U.S. GDP could be expected to raise U.S. prices by 1.5%. A 10% tariff that would do the equivalent 1.8% damage to Canadian GDP could be expected to raise Canadian prices by a relatively smaller 0.9% (see next table).
Tariff scenarios
Pressure on the U.S. Fed and Chairman Powell
President Trump’s expansive view of presidential power and defiance of historical norms continued with recent threats to fire U.S. Federal Reserve Chair Powell. Despite previously saying Powell would be allowed to serve out the remainder of his term as Chair, which ends May 2026, Trump heaped pressure on the central bank head in April, saying his “termination cannot come fast enough.” Trump, who was also critical of Powell for not cutting interest rates fast enough during his first term, said Powell is “always too late and wrong.”
Investors unsurprisingly didn’t take kindly to this political incursion into monetary policy, as central bank independence is viewed as a pillar of financial stability. The risk that politically driven rate cuts could stimulate inflation put upward pressure on long-term bond yields, while equities and the U.S. dollar also sold off. This furthering of the “sell America” trade likely contributed to Trump walking back his threats, now saying he has no intention to fire Powell.
That might not be the end of the story, though, so it’s worth examining whether Trump actually has the power to remove Chair Powell. A 90-year-old precedent that protects members of independent agencies against dismissal over policy differences (without cause) is currently being challenged in court after Trump removed senior members of several other quasi-governmental organizations.
That case could have implications for Fed independence, but even if that precedent is overturned, there are thoughts that the court could give special protection to the Fed’s Board of Governors.
It's also worth noting that Powell’s role as Chair of the FOMC – the group that sets monetary policy – is chosen by the committee itself, not the president. If Trump were to fire Powell as Chair of the Fed’s Board of Governors, it’s possible that he would still remain a member of the board as a governor while his case made its way through the courts. Powell’s underlying term as a governor does not expire until 2028.
There has been some speculation that, rather than removing Powell, Trump will install his chosen successor on the FOMC to act as a “shadow chair”, potentially undermining Powell’s authority as he serves out the remainder of his term. However, there are no vacancies on the Board of Governors until January 2026. And the Chair is just one of 12 voting members on the FOMC.
While Powell’s efforts to build consensus have seen fewer dissents against policy decisions, FOMC voters ultimately retain the ability to break ranks with the Chair (see next chart). The rest of the committee might even adopt a more hawkish stance than otherwise to establish its independence.
But Trump firing other members of the Board of Governors in an effort to alter this dynamic might be a bridge too far. Trump also has no power to remove regional presidents, which carry 5 of 12 votes on the FOMC.
The Fed has seen more consensus, fewer dissents under Chair Powell
Interestingly, the perceived front runner to replace Powell – former Fed governor Kevin Warsh – is no dove himself. He was considered one of the more hawkish members of the FOMC during his 2006-11 tenure and was critical of the Fed’s quantitative easing (QE2). Warsh supports Trump’s policies, however, thinking tariffs will have a limited inflationary impact while deregulation and spending cuts will be disinflationary. But he also called the Fed’s recent rate cuts “counterproductive” and argued the Fed should shrink its balance sheet to contain inflation.
At this point, and in light of the market’s recent push-back, Trump may now opt to let Powell serve out his final year as FOMC Chair and instead use him as a scapegoat for any tariff-driven economic slowdown. But even this would represent an unwelcome continued erosion of the central bank’s independence, which could see investors demand a higher term premium on U.S. Treasuries.
Fretting over U.S. yields
U.S. Treasury market thrown for a loop by tariffs
President Trump’s reciprocal tariff announcement sent the U.S. Treasury market on a roller coaster ride in early April. Yields initially declined as investors opted for the relative safety of government bonds, assuming the Fed would lower interest rates to offset the negative growth impact of higher import levies.
However, that move was sharply reversed the following week as 10- and 30-year U.S. Treasury yields jumped by nearly half a percent, their largest weekly increases since 2009. The MOVE index of Treasury market volatility rose to an 18-month high (see next chart). Other markets that make up the financial system’s plumbing also experienced unusual dislocation.
Treasury market volatility surged in early April
Several factors appeared to drive the increase in yields and contributed to market volatility:
No “Fed put”: Chair Powell and his colleagues suggested the Fed is in no rush to lower interest rates as tariffs could have a persistent inflationary impact and the central bank needs to keep inflation expectations anchored. That made the market’s initial rush to price in further rate cuts look misguided.
Investor positioning: Reciprocal tariff concerns caused equities to sell off, with the S&P 500 nearly entering “bear market” territory (a 20% decline from its peak). Investors covering losses in their equities or rebalancing multi-asset portfolios likely sold Treasuries, which had performed well year-to-date.
Unwinding leveraged trades: Hedge funds use significant leverage (borrowing) to exploit small price differentials in Treasury futures and swap markets, including the so-called “basis trade.” But increased volatility can force them to unwind those positions and sell Treasuries, creating a negative feedback loop of further volatility and sales.
Foreign selling: Some investors have grown uncomfortable with the U.S. market given high policy uncertainty, declining trust in the country, concerns about Executive overreach and disregard for the rule of law, and the potential for economic damage and higher inflation. Prominently, flows into Japanese government bonds suggest large Japanese investors like pension funds were selling Treasuries. Japan is the largest foreign investor in U.S. Treasuries, holding 4% of the market.
While the increase in yields was substantial and market functioning was strained, this bout of volatility fell short of recent stress episodes that required central bank intervention. The 2022 U.K. Gilt crisis, for instance, saw 30-year yields rise by 150 basis points in a matter of weeks before the Bank of England stepped in. Several months later, the U.S. regional banking crisis – driven in part by a more than two percentage point year-over-year increase in Treasury yields – required Fed intervention. And a more acute seize-up of U.S. financial markets in the early stages of the pandemic forced the Fed to buy more than $1 trillion of Treasuries in the span of a month.
This time around, comments from Fed officials that the central bank stood ready to stabilize the market if needed were enough to calm investors’ nerves, which were still frayed even after the Trump administration’s reciprocal tariff pause.
While the storm has passed, the underlying health of the Treasury market remains a concern. The Fed’s recent Financial Stability Report noted that liquidity was already low by historical standards even before April’s deterioration. Changes to post-financial crisis regulations that disincentivize banks from holding Treasuries could make them more likely to backstop the market during periods of stress. Restricting hedge funds’ leverage (reportedly amounting to 50-100x in some arbitrage trades) could also reduce the incidence and severity of self-reinforcing Treasury selloffs.
Sell America?
There was speculation that foreign investors were selling Treasuries to retaliate against the U.S.’s protectionist trade policies. That could certainly be a powerful force. Foreign “official” investors like central banks, foreign exchange authorities, and sovereign wealth funds own 14% of outstanding Treasuries. However, there was limited evidence of retaliatory sales. Foreign official sales by countries like China might have been motivated more by exchange rate stabilization, while sales by private foreign investors were likely motivated more by portfolio positioning.
That said, declines in U.S. equities and the dollar alongside higher Treasury yields – a combination more often seen when emerging markets experience stress – suggested a “Sell America” trade as foreign investors increasingly question U.S. economic and geopolitical leadership.
While there are no clear replacements for the U.S. dollar as a reserve currency, concerns about financial extraterritoriality – like the use of sanctions against bad actors – as well as the Trump administration’s growing reluctance to maintain the U.S.’s post-war leadership role in the global financial system, could see reserve managers continue to diversify into other currencies and gold. Foreign “official” holdings of U.S. Treasuries have already been more than halved from one-third of the market a decade ago (see next chart).
Foreign investors hold a shrinking share of the U.S. Treasury market
Some Trump Administration officials have even mused about making countries “pay” the U.S for providing the world’s reserve currency. They already do, in some sense, as the U.S.’s “exorbitant privilege” of supplying the global reserve currency is thought to lower Treasury yields by around half a percent.
The share of the Treasury market owned by foreign investors (not just “official” holders) has declined to 30% from 50% over the past decade. Foreign buyers have been unwilling to pick up slack from the Fed as it continues to shrink its Treasury holdings – now down to 15% of the market from a peak of 25% three years ago. Alongside growing issuance to finance persistent budget deficits, this quantitative tightening is putting upward pressure on term premia – the compensation investors receive for locking up their money in longer-term Treasuries.
The New York Fed’s measure of that premium on 10-year U.S. Treasuries rose to a decade-high of 80 basis points in April (see next chart), though that’s still below the long-term average of 1.5%. Any further increase would put even more pressure on government finances due to higher debt servicing costs. It would also make borrowing more expensive for businesses and households that are already delaying purchases and capital spending due to tariff uncertainty.
Supply-demand imbalance is pushing the Treasury ‘term premium’ higher
Real-time economic data says…
We continue to pay eagle-like attention to real-time economic indicators to get a sense for when and by how much tariffs will damage economic activity.
The initial effect of the tariffs is just beginning to come into view. Most prominently, U.S. tariff revenue is up by 44% year-to-date relative to a year ago. Most of the increase has been earned in the past month (see next chart). The mirror image to this is that importers are of course paying these tariffs – the US$43 billion in total payments so far is being sucked out of the economy. The ultimate drainage should be in the hundreds of billions of dollars for 2025, barring a sudden large-scale tariff reversal.
U.S. customs duty receipts are surging in 2025
Bank lending to businesses is surging right now, which is also likely a reflection of tariffs, as businesses are reported to have drawn on credit lines to pad their inventories before tariffs raise the cost of their inputs (see next chart).
U.S. credit is rising
Real-time consumption in the U.S. of airlines and lodging is now declining, presumably as cautious consumers cut out their most expensive and discretionary purchases (see next chart).
U.S. aggregated daily card spending: airlines & lodging
However, it must be noted that broader metrics of economic activity are still holding up just fine through late April. Overall real-time credit-card spending continues to rise and has even accelerated (see next chart – though some likely reflects household-level front-loading to avoid future price increases).
U.S. aggregated daily card spending continues to rise
Elsewhere, the Dallas Fed weekly economic index continues to trend slightly higher (see next chart). Weekly U.S. jobless claims remain low and steady (see subsequent chart). This is to say that while we can see bits and pieces of the tariffs beginning to trickle into the data, it isn’t yet apparent at the aggregate economic level.
Dallas Fed Weekly Economic Index continues to trend slightly higher
U.S. jobless claims still look fine
Lower oil prices
The price of West Texas Intermediate oil has declined from the low US$70 range per barrel to US$64 recently. That constitutes an approximate 10% decline in the price of oil (see next chart).
Crude oil prices have declined
Why the decline? The three most obvious forces are:
1. Weaker global economic growth expectations, with the implication that the demand for oil could also be lower.
2. The prospect of U.S. discussions with Iran unleashing additional Iranian oil production.
3. A recent production hike by the Organization of Petroleum-Exporting Countries (OPEC) designed to punish (via lower oil prices) and bring back into line OPEC members and partners that have been exceeding their production quotas.
A 10% decline in the price of oil might increase U.S. GDP growth by between 0.2 to 0.5%. That’s a significant amount, but not nearly enough to offset the damage from tariffs.
Lower oil prices might also reduce inflation by something like 0.4% – again, most welcome, but not enough to come close to offsetting the price shock from tariffs.
And, of course, oil prices need to stick at these levels for the full economic benefit to be delivered. In the short run, it is possible that oil prices even fall further given the eventual onset of economic weakness and the possibility that OPEC will further tighten the screws against its non-compliant partners.
But, over the medium run, it is more probable that oil prices revive somewhat, in part as some tariffs fade and damage to the international economy proves less than feared, in part as a deal between the U.S. and Iran potentially proves elusive, and in part because OPEC quotas will likely revert to a production level that supports a higher price of oil closer to US$80 per barrel.
Canadian election 2025
Election result
The Liberal Party has won a fourth consecutive election in Canada and a third straight minority victory. Mark Carney will remain the country’s Prime Minister.
The Canadian dollar is little changed, reflecting the fact that this was the most likely election outcome – though there had been a non-trivial chance of a Liberal majority before the party underperformed expectations in suburban Ontario.
Entering the year, the 2025 election theme had initially been expected to be one of disruption. But it morphed into seeking the safest set of hands after the White House levied tariffs on Canada and threatened the country’s sovereignty. In turn, the Conservative Party went from leading in the polls by a wide margin at the beginning of 2025 to losing the election.
For its part, the Liberal Party managed another of its chameleon-like transformations, with a new Prime Minister seemingly well-suited for the crisis at hand, and with policy priorities quite different than those of the party led by former Prime Minister Trudeau just a few months ago.
Relative to the prior election, the increase in Liberal support and the party’s pickup in seats is relatively modest. It has more to do with a decline in support for the left-leaning NDP and to a lesser extent the Bloc Quebecois than in support for the opposition Conservative Party. In fact, the Conservative Party is on track to win more seats than in the last election.
Minority government
The fact that the Liberals have failed to capture a majority government could prove quite consequential.
To be sure, other parties will provide their support should conflict with the U.S. intensify and a fiscal rescue or other urgent action prove necessary.
But, short of that, this could be a less stable minority government than those of the past two political terms. One reason for this is that the NDP are less of an obvious dance partner for the Liberals than before given the Liberal Party’s new focus on economy-enhancing policies and the more centrist leanings of the new Prime Minister. A second reason is that the two parties together barely clear the 172-seat threshold for holding the majority of parliamentary seats (with a combined 176 seats).
The Bloc Quebecois actually has the third most seats, after the Conservatives, and has occasionally supported minority governments, but generally on an issue-by-issue basis as opposed to as a matter of consistent policy. Perhaps there is even scope for the Liberals to work with the Conservative Party on some issues given a similar set of policy priorities – see below – but that would be quite unusual.
In turn, and especially if the Carney honeymoon gradually fades and the NDP manages some resurgence in the polls over the coming years, the NDP might be less inclined to continue supporting the Liberals, rendering this a potentially shorter-lived government. But first, the NDP will need to select a new leader and revive its party finances, and the Conservative Party will have to figure out what to do about the fact that its own leader is projected to has lost his own seat in parliament.
Policy thoughts
Regardless of which of the two leading political parties won the election, a significant shift in policy was pre-ordained.
Whereas the Trudeau era had focused on social, environmental and redistributive policies, the next government was always going to focus more on economic policy.
Some of that pivot is simply a reflection of the times we are living in, given the confluence of tariff threats, a weak economy and the urgent need to revive productivity. But some of the pivot also reflects the fact that both party leaders are ideologically to the right of Trudeau – substantially to the right in the case of Poilievre and moderately to the right in the case of Carney.
Indeed, at least at the headline level, the Liberal and Conservative parties both promised a remarkably similar set of policies: tax cuts, deregulation, more infrastructure, more resource investment, more military spending, more housing, less immigration, reducing interprovincial barriers, and stickhandling through the trade war with the U.S.
The Liberal version of these policies as selected by the voting public is not as bold as the Conservative platform on several fronts. Their platform includes relatively muted tax cuts (cancelling the proposed capital gains tax hike, lowering slightly the lowest personal income tax bracket), a partial removal of the carbon tax (eliminating the consumer-facing portion but keeping the industrial carbon pricing system), and more cautious streamlining of resource-project approvals.
Still, what remains is a strong plan for nation-building infrastructure projects, including high-speed rail between Windsor and Quebec City and development of the port at Churchill, among other objectives.
There is reason to be skeptical that the new government will manage to more than double the rate of new home construction in the country, but some increase is likely. However, the Conservative housing platform was no more likely to be delivered in full. It would appear the government will become a lot more involved in construction going forward.
The Liberal stance on trade negotiations with the U.S. under both recent prime ministers has been notably combative relative to international peers. This approach has recently been tempered and could represent an important pivot from fiery campaign rhetoric to more cautious negotiating that avoids the ire of the White House.
There is still a focus on green initiatives within the Liberal playbook, but now tilted more toward carrots (incentive-based programs) rather than sticks (carbon taxes).
The Liberal platform makes no bones about continuing to run deficits. However, this is articulated differently by separating the federal government’s operating budget from its capital budget. This approach would permit balancing the operating budget while continuing to spend more on the aggregate via the capital budget than the government takes in in revenue. That still adds up to a deficit by the usual way of accounting for things, and so is fiscally negative but economically supportive.
Both leading parties had proposed an unrealistic amount of cost savings and productivity gains to make their budgetary proposals fit together. Thus, the revenue targets are questionable. But it is clear that significant additional fiscal outlays will occur over the next four years, with C$22B budgeted for the middle-class tax cut, another C$13B to pay for the cancelled capital gains tax hike, C$18B for defense spending, C$24B for housing and C$12B in infrastructure spending. If anything, minority governments tend to be even more expensive than majority governments, as the supporting party – likely the NDP – will want policy wins of its own, probably directed toward social policies.
But the main issue in Canada for the immediate future will be tariffs, and alas the path forward on that front has more to do with decisions in the U.S. White House than in Canadian parliament.
-With contributions from Josh Nye, Vivien Lee, Aaron Ma and Ana Ardila
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