Worried that Trump's tariffs will drag down global economic growth, the market bets that the Federal Reserve will cut interest rates three times this year

On Tuesday, traders increased their bets on the Federal Reserve cutting interest rates this year due to concerns that U.S. tariff actions could drag down global economic growth. After the U.S. followed through on its threat to impose tariffs on Canada and Mexico, the money market fully priced in expectations for three rate cuts of 25 basis points each by the Federal Reserve this year, marking the first time since mid-December last year.

In early trading on Tuesday Eastern Time, the yield on the U.S. 10-year Treasury bond briefly fell to 4.1%, while the yield on the 2-year Treasury bond dipped to 3.84%, currently down 6.2 basis points and trading just below 3.89%. The yield curve steepened.

A similar trend was observed in the European market, where the yield curve also steepened as traders increased their bets on the European Central Bank cutting rates, driven by concerns that the Eurozone could be the next region facing tariff shocks. Meanwhile, the EU's aggressive defense spending has drawn market attention to its expanding government deficit, pushing up long-term bond yields in the Eurozone.

The U.S. tariff measures have also triggered retaliatory taxes from Canada. Mexican President Claudia Sheinbaum stated that her government would respond after Trump makes further decisions.

The escalating trade tensions have heightened market concerns about the U.S. economic outlook. This week's ISM manufacturing PMI data indicated that the U.S. economy is gradually approaching stagnation, making the upcoming labor market report even more critical. The market believes that if U.S. economic data continues to weaken, the strong economic growth, high inflation, and the more hawkish fundamentals of the Federal Reserve will be called into question.

Analysts pointed out that the imposition of tariffs marks a turning point in the mindset of market participants, indicating that President Trump is not only using tariffs as a negotiation strategy but is also prepared to implement them.

Mohit Kumar, Chief European Economist and Strategist at Jefferies, stated, “We still believe that tariffs are not an inflation issue but a growth issue, and we expect the yield curves in the UK and Germany to steepen further.”

Kathleen Brooks, Research Director at XTB, remarked, “These tariff risks have become a reality, and the market must reprice. As we await the U.S. non-farm payroll report to be released on Friday, the market may continue to experience volatility in the coming days.”

In addition to tariffs, news of the U.S. suspending military aid to Ukraine and the EU's plan to extend a €150 billion (approximately $158 billion) loan to boost defense spending also impacted market sentiment on Tuesday.

These developments triggered a wave of risk aversion in early trading on Tuesday Eastern Time, leading to a significant drop in global stock markets and a rise in safe-haven currencies like the Swiss franc and the Japanese yen. The Bloomberg Dollar Index fell 0.5% in early trading on Tuesday, whereas the dollar typically rises on tariff news. However, about an hour after the U.S. stock market opened, market sentiment reversed, with U.S. stocks gradually recovering from their lows and U.S. bonds turning lower.

Chris Turner, Head of Foreign Exchange Strategy at ING, stated, “There will be continuous volatility ahead. The EU's proactive defense spending plans and concerns about the U.S. economic outlook are currently putting pressure on the dollar. However, we still believe that the dollar will generally strengthen in the first half of this year.”