Tariffs a one-time price shock for U.S.

Lingering policy uncertainty could trigger more volatility

“Life is like being at the dentist. You always think the worst is still to come, and yet it is over already.” Otto von Bismarck’s quip comes to mind as I think about the recent teeth-gnashing from investors amid a modest pickup in market volatility.

Perhaps we had grown too accustomed to the benign market environment that emerged in 2024 as inflation waned and policy clarity improved. Not long ago, investors were anticipating that the U.S. Federal Reserve (Fed) would cut interest rates six times by the end of this year.¹ Fast forward to a few strong economic data releases and inflation remaining at the upper end of the Fed’s perceived “comfort zone,”² and all but one of those rate cuts have been priced out of the market.³ The new presidential administration’s tariff and immigration policies likely compounded the uncertainty. And as I’ve said before, market drawdowns and volatility are almost always the result of policy uncertainty.

That brings me back to Bismarck. If the market has already priced out the rate cuts, wouldn’t that suggest that the policy uncertainty and market volatility are over already and that the worst isn’t to come? I suppose that could be false hope, and investors may need to brace themselves for additional volatility, but I suspect we know this drill (all puns intended, #dadjokes).

It may be confirmation bias, but the inflation concerns are likely overdone. The December U.S. payroll report may have been a big surprise, but it provided further evidence that the labor market is not a significant source of inflation.⁴ Wage growth for non-managerial employees came in at the lowest since 2021 and is below the 10-year average.⁵

Remember the sticky shelter inflation? It should have come as no surprise that shelter inflation had been sticky. It’s not as if rents reset daily. It was going to take time. The growth in owners’ equivalent rent – what a homeowner would pay if they rented their home – has been trending lower and appears to be moving toward its long-term average.⁶

Bond vigilantes: Are they back?

Many investors sound like the little girl in Poltergeist II: “They’re back.” Admittedly, I never saw that sequel, so I can’t tell you how it ends. Accidentally seeing the first one while still in grade school was distressing enough for me, but I digress.

I find it hard to believe that the recent spike in the 10-year U.S. Treasury is a sign that the bond vigilantes are back to bully the fiscal policymakers. Rather, long-term Treasury rates appear to be following the lead of the Fed.

Long rates plunged in the fall when the Fed pivoted from its tightening stance.⁷ Long rates surged in the winter as strong U.S. nominal growth diminished rate cut expectations.⁸ I expect the bond market to continue to reprice based on U.S. nominal growth and its impact on Fed expectations, not on the fiscal health of the country. A few weaker-than-expected economic data releases are likely all it would take for investors to forget about the bond vigilantes.

Politics with mixed company

I spent the last year telling investors that elections haven’t historically mattered much for markets. It’s been somewhat validating that the so-called “Trump trade” dissipated quickly. The S&P 500 Index has been essentially flat since the election, as investors rightfully turned their attention away from politics to U.S. growth and the path of monetary policy.

We’re also getting a lot of questions about tariffs, so here are a few points to consider:

• I believe tariffs should be seen as a one-time price shock rather than the start of a new inflationary trend. In 2018, there was a noticeable price increase in tariff-affected categories, but the prices of other core goods remained unaffected.⁹
• Tariffs are expected to result in less optimal economic outcomes but are unlikely to drive the U.S. economy into a recession. A bigger risk to the economy is a prolonged period of uncertainty related to trade policy, which could hinder “animal spirits” and result in declining activity.
• Risk assets were challenged during the prolonged trade war in 2018, only for the bull market to continue once greater clarity regarding the terms of trade emerged.¹⁰

Brian Levitt is Global Market Strategist at Invesco and cohost of Invesco’s “Market Conversations” podcast.

Notes

• 1. Source: Bloomberg L.P. Based on Fed Funds implied rates in September 2024.
• 2. Source: US Bureau of Labor Statistics, 12/31/24. Based on the US Consumer Price Index.
• 3. Source: Bloomberg L.P., 1/16/25. Based on fed funds implied rates.
• 4. Source: US Bureau of Labor Statistics, 12/31/24.
• 5. Source: US Bureau of Labor Statistics, 12/31/24.
• 6. Source: US Bureau of Labor Statistics, 12/31/24.
• 7. Source: Bloomberg L.P. The 10-year US Treasury rate fell from 4.70% in April to a trough of 3.62% in September.
• 8. Source: Bloomberg L.P. The 10-year US Treasury rate climbed from a trough of 3.62% in September to a recent peak of 4.79% in the middle of January.
• 9. Source: US Bureau of Labor Statistics, 12/31/24.
• 10. Source: Bloomberg L.P., 12/31/24. Based on the returns of the S&P 500 Index in 2018 and 2019.

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