Market sentiment takes a sharp turn: Trump trade turns into recession trade?

Source: Jinshi Data

Bond traders are signaling a growing risk of economic stagnation in the U.S., given Trump’s chaotic tariff policies and federal government layoffs.

Less than two months into Trump’s presidency, speculation that he would inject stimulus into the U.S. economic expansion and keep putting upward pressure on Treasury yields is quickly being thrown out the window. Instead, traders have been buying short-term Treasurys in droves, with two-year yields falling sharply since mid-February on expectations that the Federal Reserve could resume cutting rates as early as June to prevent the economy from worsening.

“Just a few weeks ago, we were being asked if we thought the U.S. economy would reaccelerate — and now, the word ‘recession’ is suddenly being mentioned repeatedly,” said Gennadiy Goldberg, head of U.S. interest rate strategy at TD Securities, referring to the risk of a recession. “The market has gone from optimism about economic growth to outright despair.”

The change marks a sudden reversal in the Treasury market. Over the past few years, the main driver of the Treasury market has been the surprising resilience of the U.S. economy, even as growth has slowed overseas. Investors’ initial bets on the outcome of the presidential election only exacerbated that trend, sending Treasury yields sharply higher late last year on expectations of faster growth and higher inflation — a pillar of the so-called “Trump trade.”

However, since mid-February, as the new administration’s policies have created great uncertainty about the economic outlook, Treasury yields have begun to fall, with short-term bonds leading the decline, steepening the yield curve, which typically occurs when investors expect the Federal Reserve to start easing monetary policy to stimulate economic growth.

A key driver is Trump's brewing trade war, which is likely to bring another inflationary shock and disrupt global supply chains. Stocks sold off last week as a result, and the sell-off continued even after Trump once again postponed tariff increases on Mexico and Canada. The government's move to freeze federal funds and lay off tens of thousands of government workers also had a negative impact.

“The risk of a recession is definitely higher because of the sequencing of Trump’s policies — tariffs first, then tax cuts,” said Tracy Chen, a portfolio manager at Brandywine Global Investment Management.

Trump responded to concerns about the risk of a slowdown by saying on Sunday that the U.S. economy faces “a transition period.” U.S. Treasury prices rose during Asian trading on Monday, with the benchmark 10-year yield falling below 4.27% at one point.

The divergence between European and U.S. bond markets last week highlighted the shift in sentiment.The two markets typically move in sync. Yet while German bond yields surged on expectations of increased defense spending to make up for reduced U.S. support for Ukraine, U.S. Treasury yields barely budged.

Of course, bond traders have positioned themselves for a possible recession several times over the past few years, only to be thwarted each time by the economy moving forward. Moreover, the three 25 basis point rate cuts they currently expect from the Fed this year are not enough to indicate that the Fed is entering recession-fighting mode. On Friday, Fed Chairman Jerome Powell said he was in no rush to resume accommodative policy, saying that "the economy is in a good place, although uncertainty is high."

Inflation is likely to continue to put upward pressure on yields, with this week's Consumer Price Index (CPI) report expected to show that prices rose 2.9% year-on-year in February, still above the Fed's 2% target.

However, signs that the economy is cooling are also accumulating, including the Atlanta Fed's GDPNow indicator, which shows that U.S. gross domestic product (GDP) may have contracted in the first quarter.

While the Labor Department reported that job growth was maintained in February, its report on Friday also provided evidence of a weakening labor market, including more permanent job losses, a decline in federal government employees, and a surge in the number of people working part-time for economic reasons.

The details of the (employment) report show much worse, and the forward-looking aspects of the report seem to have driven the continued rise in Treasury prices. The data supports the Federal Reserve's early rate cuts and exacerbates market concerns about a recession, so it should continue to drive the recent trend of a bull market in bonds and a bear market in stocks in the U.S. financial markets."

The direction of the U.S. Treasury market depends largely on how Trump's policies are implemented in the coming months.U.S. Treasury Secretary Scott Bessent acknowledged on Friday that the economy may be turbulent due to the administration's policies, but he expressed confidence in the long-term prospects of the economy.

On Thursday, Trump seemed to respond to some concerns about the administration's aggressive cost-cutting measures by instructing cabinet ministers to use "scalpels" rather than "axes" when cutting jobs. He also delayed a second tariff increase on Mexico and Canada by a month as stocks plunged.

“Before this trade war, the market thought tariffs would cause inflation, and now people think tariffs will cause a recession,” said Chen of Brandywine Global Investment Management. “So it’s a huge shift.”