Are tariffs inflationary or deflationary? That is the question. Or maybe, they’re both.
Economic orthodoxy says tariffs are inflationary, but the prevailing characteristic of US President Donald Trump’s first 73 days in office has been his willingness to disregard all orthodoxies, economic or otherwise. And the initial reaction to his ‘Liberation Day’ tariffs last week was equities down, government bonds up — in other words, markets see them as a growth shock rather than an inflation shock.
The inflation angle still matters, even if markets had already largely priced in higher prices and feel they now have the leisure to worry about growth instead. Inflation determines the amount of room central banks will have to ease policy to counteract the recessionary impact of the levies.
Futures markets are showing that investors have ramped up their bets that the Federal Reserve will cut US interest rates as many as five times this year, up from four on Friday and fewer than three early last week.
Demand destruction
The current market narrative goes something like this: ‘The US consumer is becoming increasingly stretched (see the three terrible prints this year on the University of Michigan consumer sentiment index), and now imported goods are going to cost significantly more.’ These goods tend to be, but are not exclusively, at the more luxury end of the market, and therefore consumers can be expected to simply stop spending, rather than pay more. This can be considered demand destruction rather than supply restriction and could exacerbate recessionary pressures.
At the same time, there are concerted efforts to reduce supply-side inflation on raw materials. Oil-producing nations are under pressure to increase output (such as the agreement by eight OPEC members on 3 April to raise production by over 400,000 barrels a day). There are also increasingly urgent demands on all parties to resolve the war in Ukraine to accelerate the flow of commodities out of the region. While these moves aim to ease inflationary pressures on essential goods, they do little to address the broader recessionary risks posed by demand destruction.
Waking the inflation beast
So what’s next? Looking too far ahead feels foolhardy in such uncertain times. The immediate focus remains on the fallout from the tariff announcements, potential retaliation by other countries, and the corporate impact revealed during the forthcoming quarterly earnings season.
If one does brave a glance down the track, the most important data in the coming months will centre on fundamental releases related to inflation, confidence and jobs. While any rise in expectations for faster rate cuts could help mitigate the economic impact of tariffs, central banks must still carefully balance stimulating growth against the risk of waking the slumbering inflation beast.
High yield bonds: The end of US exceptionalism?
One of the most dramatic casualties of last week’s announcements has been US high yield bonds, particularly those issued by CCC-rated companies.
These highly leveraged issuers are often seen as a bellwether for risk appetite and sentiment about the global economy’s health, and the sharp sell-off in US CCCs suggests confidence has been badly shaken.
In our view, pricing is now more commonsensical. One of the curiosities had been how overpriced US CCCs had become over the past two years compared to European issuers, which in our view showed overconfidence in the strength of the US economy and the stability of its political landscape.
At the end of December 2024, European CCCs offered a spread of 1347 basis points (bps) versus their US counterparts’ 730 bps. In November 2024, European CCCs offered double the spread of US equivalents (1446 bps versus 722 bps).
Wake-up call
On 4 April, two days after the announcement, this difference had shrunk to less than 300 bps, after investors woke up and realised they weren’t being fairly compensated for default risk in a materially weaker economic environment, triggering the current sell-off.
Figure 1. High yield bond credit spreads: CCComing together again?
Source: ICE BofA Index Data. ICE BofA CCC & Lower US High Yield Index & ICE BofA CCC & Lower Euro High Yield Index Option Adjusted Spreads as at 4 April 2025. Indices are unmanaged, and one cannot invest directly in an index.
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Investors in Europe — where factors such as sluggish growth, energy supply issues and proximity to the Russia/Ukraine conflict have been widely signposted — have demanded a sufficient risk premium to support these companies. In our opinion, that’s why Europe has been a much happier and more dispersed hunting ground for opportunities. Also, CCCs account for 11% of the US junk bond market, compared to just 6.5% in Europe; meaning that the overall quality of the European market is higher than that of the US.
Whilst US CCC bonds have been notable underperformers, we've seen risk-off rhetoric ripple across the wider credit markets — spreads have risen across the piste. We have seen the usual flight towards government bonds; yet, the scale of the credit repricing has thrown up opportunities. We'd expect a modest pick-up in underlying corporate defaults; however, spreads are beginning to offer a healthier level of compensation — especially at the idiosyncratic level.
Going forward, we expect volatility on both sides of the Atlantic. The gap between euro- and US dollar-denominated CCCs may change, as the EU considers its own response to ‘Liberation Day.’ But at least, from a pricing perspective, we see a bit more common sense in US markets.
All data Bloomberg unless otherwise stated.
With contributions from Adam Singleton, CIO External Alpha, Man Group, Jon Lahraoui, Director Discretionary Credit, Man Group and Mike Scott, Head of Discretionary Global High Yield and Credit Opportunities, Man Group.
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