How does the market price the risk of "stagflation" in the United States?

Trump's tariff war is escalating, and the global market has just experienced a Black Monday. For the market, there are many issues that need to be clarified, but what is relatively clear is that Trump's tariff policy is likely to last for a long time and will have a profound impact on global trade and geopolitical patterns. Because of this, investors are beginning to pay attention to the rising "stagflation" risk in the U.S. economy; interestingly, the market is also starting to bet that the Federal Reserve will cut interest rates more quickly and more significantly to counter the risks of economic downturn. The Federal Reserve's meeting in May is the first observable policy window, but some market commentators believe that the Fed may take emergency rate cuts even earlier.

The first window to observe "stagflation" is the yield spread between 2-year and 30-year U.S. Treasuries. From recent trends, the 30-year Treasury yield has seen little significant change, while the 2-year yield has almost plunged, indicating that while the market is pricing in Fed rate cuts, it also believes that future inflation risks are still worth noting. In other words, the market is trading "economic stagnation" and "inflation" separately, rather than generally believing that "stagflation" could severely constrain monetary policy—because rate cuts could exacerbate inflationary pressures. From another perspective, the market is more convinced that the Fed will take easing measures while also believing that inflationary pressures will persist in the medium term.

At the same time, we also find that the yield curve between 2-year and 10-year U.S. Treasuries has begun to steepen significantly, which seems to signal a bottoming out of the U.S. dollar index. In previous analyses, we found a good correlation between the dollar index and the 10-year Treasury yield, but rarely studied the relationship between the yield curve and the dollar index. The reason behind this is that yields on bonds of different maturities tend to rise and fall together, which means that the yield spread is relatively stable, so there is no need to pay excessive attention to it. However, as the recent yield spread has begun to widen, the underlying logic will also affect the dollar's dynamics. For example, many investors believe that the U.S. economy will experience "stagflation," but many other economies may face severe recessions, which to some extent brings a relative advantage to the dollar. From this perspective, the market has begun to clearly price in the impacts of tariffs on different economies.

From the perspective of the euro, the main counterpart of the dollar index, the narrowing of the U.S.-Europe yield spread is another noteworthy event recently. Generally speaking, this seems to correspond to a peak in the euro exchange rate. In other words, if the dollar index rises, and the yield spread of U.S. Treasuries begins to widen while the U.S.-Europe yield spread narrows (indicating that the Eurozone economy may be weaker), the market still seems to believe that Trump's tariff policy is "killing a thousand enemies while harming eight hundred of its own."

Author of this article: Zhou Hao, Sun Yingchao, Source: GTJAI Macro Research, Original title: "How Does the Market Price the Risk of U.S. 'Stagflation'?"

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