Are global trade tensions driving Treasury bond yields higher?

It has become common in finance to hear the recent rise in U.S. bond yields blamed on escalating trade tensions. This notion is misguided. A more thorough look at the basic economics suggests that higher tariffs could eventually cause bond yields to fall.

For starters, news of an impending “trade war,” and concerns about the attendant consequences, have run ahead of actual developments. We can put the scale of this potential conflict into perspective. In 2017, the United States imported $2.3 trillion of goods and services, accounting for just 11 percent of the nearly $20 trillion in GDP. The announced tariffs will affect less than $70 billion of goods, or 3 percent of annual imports and only 0.3 percent of GDP. Indeed, the announced tariffs could eventually affect much less than this amount, due to waivers for our trading partners.

{mosads}President Trump has threatened additional tariffs on up to $100 billion of goods, which would clearly represent an escalation. But it remains to be seen how the next phase of the negotiations will play out, and it is unlikely that bond traders have enough conviction on the outcome to fully reflect such threats in market pricing. Those attributing the rise in bond yields to tariffs often focus on inflation, arguing that tariffs raise prices of imports and will thus cause inflation, but this is where they appear to get the economics wrong.

Low inflation is fundamentally a reflection of tepid nominal spending growth. Low nominal spending growth has characterized the U.S. economy for the past decade, playing a leading role in keeping inflation below the 2 percent Federal Reserve target for the better part of the last five years. It is unlikely to change materially in the near term.

As long as nominal spending growth remains subdued, businesses will be unable to raise prices without depressing demand. In this context, any exogenous increase in prices, due to tariffs, for instance, would likely be absorbed by a reduction in business margins. Price increases not absorbed by margins may get passed on, but they will subsequently lower consumer demand, leaving total spending unchanged. In either case, changes in prices will fail to boost nominal spending, and without that boost, inflation is likely to remain sluggish.

A related point is that those linking tariffs to bond yields get the timing wrong. An increase in tariffs would represent higher prices today, but bond yields reflect the future rate of inflation. Absent subsequent rounds, there is no obvious reason why prices should rise again, and thus no reason why the future rate of inflation should increase.

This is not to say that tariffs do not matter. As noted above, a one-time increase in prices today may weigh on future consumer demand. Another possibility is that an escalation of trade tensions could disrupt business supply chains and sentiment, which could in turn actually depress investment and economic activity.

It is commonly noted that the Smoot-Hawley tariffs in 1930 coincided with the onset of the Great Depression. It would be wrong to fully ascribe the economic collapse to those tariffs, but careful empirical work does confirm the expected link between higher tariffs and a decrease in U.S. economic activity. What can be said with absolute confidence is that the Smoot-Hawley tariffs did not presage a period of elevated bond yields.

Given the focus on trade tensions, market prices likely already reflect some of the associated risks. These risks may be weighing on the prices of equities and perhaps corporate credit. However, we do not think that these risks have contributed to higher bond yields. Basic economics suggest that, if anything, an escalation of trade tensions would eventually lead to lower bond yields. The way forward is obviously uncertain.

We may have seen the worst of the trade tensions, and the announced tariffs could prove manageable. The news could even improve, from a negotiated détente or agreements in other areas. However, we cannot entirely discount the possibility that trade tensions will get worse. Those investors who fail to get the basic economics right could be surprised by the fall in bond yields that would likely follow such an outcome.

John Bellows, Ph.D., is a portfolio manager at Western Asset Management, a subsidiary of Legg Mason. The opinions expressed in this column are not meant to be viewed as investment advice or a solicitation for investment.