Another tumultuous week has followed for financial markets. On the heels of last week’s announcement that the U.S. would implement higher reciprocal tariffs on a number of countries, some appeared to have reached out for negotiation, while a few others announced their own countermeasures. What stood out was China’s commensurate retaliation to the 34% additional U.S. tariff on Chinese goods. But this was only the beginning, with the trade fight escalating throughout the week. As higher reciprocal tariffs came into effect, equity markets sold off. Normally when this happens, Treasuries (considered a safe-haven asset) tend to rally. But, in a very concerning move, Treasuries sold off too. Yields (which move opposite to bond prices) shot higher. The dollar also lost considerable ground against a basket of foreign currencies. Before long, the White House appeared to extend an olive branch. In a surprising move, Pres. Trump announced a 90 day pause to last week’s reciprocal tariffs, while also lowering the country-specific rate to a universal 10% for all targeted countries, except for China. Tariffs on the latter were jacked up further. Stock markets rejoiced initially, staging a sharp recovery on Wednesday. But when it came to yields and the dollar, the weak trends described above resumed later in the week (Chart 1). 

Pulling back the lens on the many twists and turns from this week’s events, one thing is clear – the U.S. is softening its tariff stance with most partners targeted last week, but is tightening the screws on China. The White House has clarified that the tariff increases on China so far add up to 145%, while this morning China announced it will increase retaliatory tariffs on U.S. goods to 125%. If tariffs were to hold at these high levels for a while, a large chunk of trade with China would effectively be cut off. While China’s economy would undoubtedly take a hit, as its $439 billion worth of goods sent to the U.S. last year dwindle to something much lower, there will be major consequences at home too. Reduced access to the Chinese market for U.S. exporters is a first. But perhaps a more concerning aspect is the prospect of product shortages, along with higher prices for inelastic products that can’t be sourced from elsewhere in short order. Domestic production cannot fill the void that will be left by China over the near-to-medium term. In this vein, the trade war will also remap supply chains, with the U.S. inclined to seek product substitutes from other countries, while Chinese exporters will seek to expand in other markets, such as in Europe. 

Apart from leaving a mark on financial markets, trade uncertainty is also weighing on consumers and businesses, with the NFIB small business confidence measure continuing to trend lower in March. On a more positive note, producer prices, and inflation as measured by CPI, both came in softer than anticipated last month. Lower energy prices dragged down total CPI inflation (2.4% year-on-year (y/y)), but core inflation also eased, cooling to 2.8% y/y from 3.1% previously. Still, considering the tariffs and the fact that consumers are positioning for higher inflation, this trend looks set to reverse course soon (Chart 2). This leaves the Fed in a difficult position. Minutes from the mid-March FOMC meeting suggest that the central bank wasn’t ready to alter its course yet, with Fed officials leaning against preemptive rate cuts. While a lot has changed in the last three weeks, messaging from Fed officials appears consistent, with several speeches this week driving home the point that the bar for rate cuts remains high.