Market Minutes

The gap between U.S. productivity and the hourly wage paid to nonsupervisory employees continues to widen.

If anything, the gap is accelerating as the American economy continues to be transformed by the global supply chain and technological advances. 

One result has been the erosion of workers’ pay. During the postwar era of industrialization until 1979, wages in nonsupervisory occupations grew at roughly the same rate as productivity. That is, wage growth was directly associated with the growth of output.

Since 1979, however, that relationship has broken down. Nonsupervisory wage growth flattened out through 1995 and has grown only modestly since then, all while productivity has advanced.

Workers have taken notice: They are producing more, but they aren’t seeing the benefits. Class resentment has followed.

Today, the result is the K-shaped economy, in which those with higher incomes are benefiting from the rise in productivity while those with lower incomes, in the bottom of the K, are not.

The United States is not the only economy going through this transition. East Germany is a hotbed of discontent as manufacturing has been usurped by cheaper labor and higher productivity in China.

In the UK, discontent is quite serious in the midlands and in the northern area of the country.

As the U.S. enters a period where millions are facing sharply higher medical insurance premiums and as artificial intelligence is stirring anxiety among workers over the potential loss of millions of jobs, the discontent is likely to grow.

India’s rupee broke above a benchmark barrier of 90 rupees per dollar recently, continuing a 10-year weakening trend even as its economy is expected to grow at a rate of 6.2% per year.

This latest bout of rupee weakness has been attributed to the breakdown of trade talks, with the U.S. imposing an effective tariff rate of about 35% on imports from India.

The softening came amid reports that the Bank of India was selling small amounts of dollars, which moderated the rupee’s decline.

Still, the rupee has been depreciating at 3.7% per year since the start of the Modi administration in 2014. And the forward market is now projecting a 3.1% yearly decline over the next five years.

In its latest assessment of India’s economy, the International Monetary Fund finds that faced with an uncertain external environment, an easing of monetary policy and greater exchange rate flexibility would help India absorb external shocks.

The balance sheets of global firms operating in India would be affected by a liberalized policy structure—implying more volatility, not less, and requiring more sophisticated hedging strategies.

The Modi administration has already undertaken structural changes that have facilitated domestic private consumption and improved living standards.

India is less exposed to global trade than other Asian economies, and its large domestic market holds the potential for resilience and growth.

In our view, the Bank of India’s intervention in the foreign exchange market is a stumbling block in that country’s effort to attain developed-market status.

The foreign exchange market is the first line of defense for any economy, a buffer to both external and domestic shocks.

An absence of government interference in the foreign exchange market would allow for the expansion of India’s bond market and encourage foreign investment in India’s assets. Both are necessary components of the greater national modernization project in India. 

Demand for lending remains brisk across the economy. But a look at loan growth over the past year illustrates a large divergence in loan provisions to traditional borrowers versus nondepository financial institutions.

The divergence speaks volumes about risk—think private credit, private equity and cryptocurrency—and the growing imbalances underscoring the American economy.

It vividly portrays the growing risk of leverage across financial institutions inside an increasingly financialized economy.

Through mid-October, credit to nondepository financial institutions had increased by 44.6% from a year ago in contrast with the more pedestrian 4.5% increase among traditional borrowers.

Given the increase in leverage across the economy to chase returns, the idea of a K-shaped lending market should be of little surprise.  

It fits within the context of a financialized economy driven by low rates, liquidity and leverage.

Anyone who has been paying close attention to the evolution of risk and the American economy understands that imbalances like that cannot endure indefinitely. 

One of the more interesting phenomena in the economy these days is the seeming disconnect between economists’ muted forecasts of long-term interest rates and the arrival of expansionary fiscal policies next year.

According to a Bloomberg survey of economists conducted in mid-November, respondents expect the U.S. 10-year Treasury yield to end 2026 at 4.07%, just below the 4.09% at the time of the survey, and the 30-year yield to stand at 4.61% compared with the current 4.69%.

One would think that given the imminent arrival of tax cuts and the full expensing of capital expenditures, yields would be rising to reflect greater risk-taking as investors and the government compete for scarce capital.

But the economic forecasting community expects that these policies will  result in only a 1.8% growth rate next year.

What gives?

In our estimation, long-run yields remain muted because of pervasive uncertainty linked to the policy incoherence around trade, the status and constitutionality of tariffs, restrictive immigration policies, and the impact of the longest government shutdown in U.S. history.

If economic history is any guide, long-term rates should be rising. Expansionary policies, like the Reagan tax cuts of the 1980s, have traditionally spurred strong growth—and inflation is on the rise again, increasing by 3% over the past year and by 3.6% at an annualized pace over the past 90 days as of mid-November. 

It is a sign of the times that while businesses are now looking to expand, a modest majority of lenders have retained their more cautious approach.

We expect an increase in loan demand as well as a less cautious risk stance among lenders, though, as the administration follows through on a more aggressive form of deregulation across the banking industry.

This will most likely be part of what we expect will be a reacceleration of growth next year following an uneven year because of the broad policy changes across trade and immigration.

The Federal Reserve released its quarterly Senior Loan Officer Opinion Survey on Bank Lending Practices on Oct. 31, roughly covering the months of the third quarter.

On the demand side, the survey found stronger demand for commercial and industrial loans from large and middle market firms; demand among small firms was basically unchanged.

On the supply side, a modest majority of lenders reported tighter standards for commercial and industrial loans to firms of all sizes. Although this was an improvement over surveys taken earlier in the year, the banking community continues to show a reluctance to take on risk given the economic uncertainty.

Similar to C&I lending, a modest net share of banks reported stronger demand for commercial real estate loans over the third quarter and unchanged standards for those loans.

Finally, both the supply and demand for commercial lending follow the trend in the RSM US Financial Conditions Index. This suggests that borrowers and lenders are more willing to take on investment risk at times of improved economic activity.

Financial conditions are moderately accommodative, which implies less investment risk than would normally be expected. The recent movement in financial conditions, however, best resembles being stuck in neutral.

As we illustrate, monetary policy is transmitted to the economy via changes in the policy rate. An increase or decrease in the policy rate directly affects financial conditions and the degree of risk priced into the cost of credit.

A reduction in the Fed’s policy rate decreases the day-to-day cost of doing business, which reduces prices and stimulates consumer spending.

That spending dictates the level of economic activity and the level of inflation as the demand for goods increases or decreases.

While we are certain that lower rates, increasing liquidity and rising leverage bolster financial activity among businesses and higher-income households, these benefits are taking longer to reach lower-income households than in the past. 

One positive aspect of the disruption of global trade relationships by Washington is the extraordinary increase in tariff revenues.

The U.S. Customs and Border Protection agency is now collecting tariffs at a rate of $30 billion per month compared with the $6.8 billion per month normally collected from importers.

That means that in the six months since the tariffs were enacted, CBP has already collected roughly $110 billion more in custom duties than it otherwise would have.

Before this year, custom duties accounted for about 1.3% of total government revenue. Customs receipts are now approaching 4% of total revenue and would move higher if tariffs were to continue.

But there’s a catch. As happened during the 2018−19 trade spat with China, when a good portion of that revenue was used to subsidize American farmers hit by tariffs, whatever revenue gains are generated this time around will most likely be redirected to support soybean farmers whose exports to China have collapsed, or be used to pay for assistance to lower-income households in the U.S.

Bailing out American farmers would result in tariffs becoming another transfer payment, taking money from importers and the public and giving it to a protected group, which then becomes difficult to end.

Additionally, there is a chance that the Supreme Court may declare tariffs unconstitutional, forcing the government to refund the tariff money to importers.

If that happens, the loss of revenue would further strain the U.S. budget, with the increase in debt pressuring long-term interest rates higher.

At the same time, it would restore the revenue and profitability of corporations that have absorbed the tariffs, which would increase their tax payments.

For the importers that were able to pass along the tariffs to consumers, it is hard to imagine households benefiting directly from rebates, except perhaps through lower prices in the future.

We also anticipate that the administration would declare almost anything having to do with China as a national security risk under section 232 of the Trade Expansion Act, which would result in a far smaller rebate to U.S. corporations that have absorbed the tariffs through thinner margins.

Data provided by the Bank for International Settlements shows that the U.S. dollar continues to dominate foreign exchange markets.

In its latest triennial survey, conducted in April and published in September, the BIS found that the dollar was on one side of 89% of all international transactions, an increase from its 88% share in 2022.

The euro’s share of spot transactions fell to 28.9% from 30.6% in 2022, while remaining the currency of choice for nearby developing markets.

The Japanese yen’s share was virtually unchanged at 16.8%, and the British pound sterling declined to 10.2% from 12.9%.

The BIS also noted that sales desks in the United Kingdom, the United States, Singapore and Hong Kong account for 75% of all FX trading, highlighting the importance of international finance in those economies. 

Hedging the dollar’s value

The BIS observed that the April survey was conducted at a time of elevated volatility on FX markets and a surge in trading that followed trade policy announcements.

As we have noted, there is a growing consensus that while global investors would continue to purchase U.S. financial assets for their high returns, the dollar was likely to depreciate after years of strength, prompting investors to hedge their exposure to the dollar.

We see this playing out in the increased share of spot transactions and outright forwards used to lock in future exchange rates. Additionally, in the average daily turnover of FX options, which are mainly used to hedge currency risk or to speculate on currency movements, option activity more than doubled from 2022 to 2025.

Finally, the BIS analysis noted the critical role of FX swaps, which typically combine a spot transaction with an outright forward and are widely used to manage FX funding liquidity and to hedge currency risk.

Currency swaps, by contrast, are mainly used to manage longer-term exposure and to hedge currency risk. Since they typically have longer maturities than FX swaps or outright forwards, their daily turnover tends to be much lower.

Why was the Federal Reserve’s recent 25-basis-point rate reduction so important? It is a question I often heard as I traveled the country speaking about the economy.

The truth is that for most Americans, a quarter-point rate cut is not that important. At best, consumers get a modicum of relief on the average 21.1% variable interest rate they are paying on their credit cards while their rates on auto and home loans fall by a few basis points.

So even though those payments become a little less expensive, that answer does not adequately explain the sound and fury that accompanied the debate leading up to the Fed’s rate cut on Sept. 17. 

Why all the angst?

On Wall Street, low rates, liquidity and leverage are the holy trinity of new finance.

Those low rates create conditions at the front end of the curve that result in rising liquidity, which then permits those who work in modern finance to increase leverage to chase higher returns across asset markets.

On Wall Street, money matters and credit counts. Low rates spur risk-taking through higher leverage, which then stokes credit-fueled expansions that benefit those who work in modern finance.

Lower rates at the front end of the Treasury curve support greater risk-taking—hopefully, well hedged—which generates outsized returns and in turn drives asset prices higher. 

The intense debate over whether the Fed should cut its policy rate is another reminder that the realities of Main Street are quite different from those on Wall Street.

One alternative measure of economic activity is the sales of heavy trucks, which move everything from food to basic materials to retail goods.

Since 1979, when the data became available, a collapse in sales of heavy trucks has coincided with recessions. The recent downturn in heavy truck sales, which started in 2023, should be a concern for policymakers.

We note, however, three episodes in which a drop in heavy truck sales did not precede a recession. Rather, those declines turned out to be midcycle corrections that presaged a recession by several years.

Looking at the year-over-year growth of heavy truck sales and real gross domestic product growth, we notice a correlation from 1979 to 2009 and more deviation thereafter.

Clearly, while heavy truck sales growth has been predominantly negative during the past 24 months, real gross domestic product growth has remained positive, averaging 2.7% over the same period.

This perhaps speaks to underlying changes in the economy as it moves further from production to intellectual activities. There is an underlying strength in the economy.

As Fed Chair Jerome Powell said in August at the annual Jackson Hole Economic Symposium, the economy has shown resilience amid sweeping changes in policy, all of which makes for difficult decision making for the Federal Open Market Committee.

Global oil production has resulted in an oversupply that, if sustained, will drive prices down toward breakeven levels and trigger consolidation among domestic producers.

Futures prices for the benchmark West Texas Intermediate in mid-September fell below $61 per barrel for 12-month forward contracts after OPEC+ announced it intends to increase production.

While this is all good news for U.S. households and businesses anxious about inflation, the price of $62 per barrel in mid-September was perilously close to the breakeven price for U.S. producers. In short, lower prices will make it tougher for U.S. producers to remain competitive with OPEC+.

Current estimates of the breakeven rate for U.S. producers range from $61 to $70 per barrel, depending on the producer’s size and region.

That price level implies that the recent push by OPEC+ for increased production will make it difficult for U.S. producers to maintain output and market share.

As we show below, the number of rigs and the price of crude are historically related. But the global energy market is complex, with the relationship between supply and demand distorted by a cartel of highly efficient suppliers and with demand undergoing a structural shift.

The latest decline in rig count reflects greater efficiency among U.S. producers and weakening demand as consumers shift to electric vehicles and more energy-efficient homes. 

In the end, if OPEC+ continues to increase production, there is a growing risk that smaller and less efficient U.S. oil producers will fall by the wayside, costing U.S. market share and jobs.

The domestic technology sector is currently the strongest driver of the American economy. Amazon, Google, Meta and Microsoft cumulatively plan to invest more than $364 billion in developing their respective artificial intelligence infrastructure.

All of this infrastructure, including data centers, will require vast amounts of energy, and the price of that energy will ultimately hit consumers.

Domestic electricity inflation in the July consumer price index increased by 9.5% on a six-month average annualized basis. While that increase is below the cyclical peak of 20.63% during the pandemic-era inflation shock, it will likely move higher.

From 2010 to 2019, CPI electricity inflation increased by 11.77%. More recently, that figure has spiked. Between 2020 and July 2025, it increased by 37.87%, a figure mostly attributable to demand from the tech sector.

With firms like Nvidia pledging to invest $500 billion to manufacture AI-enabled chips in the U.S., the price of domestic electricity is likely to soar.

The question is how consumers will respond as their utility bills increase, and whether that rise will lead to expanding the range of resources dedicated to generating power. 

One reason that the discussion of de-dollarization is a bit overdone is because of the structure of global financial markets and the overnight liquidity needs among the global systemically important banks as well as other financial intermediaries.

Serving these liquidity needs is the $12.1 trillion American repurchase, or repo, market, which settles in U.S. dollars.

Think of it as the modern version of what in the postwar era was called American exorbitant privilege.

The U.S. repo market consists of short-term collateralized borrowing and lending, with dealers often taking simultaneous positions on either side of separate transactions.

The repo desk at the Federal Reserve Bank of New York is charged with facilitating monetary policy by keeping overnight rates within the range announced by the Federal Open Market Committee, and by maintaining liquidity in the short-term money markets in times of financial stress.

Yes, some economies will shift away from holding dollar-denominated assets to reduce their support of American monetary dominance. But the euro, yuan, pound and yen simply do not have the depth or breadth to support the liquidity needs of the systemically important banks and other large financial intermediaries worldwide.

Any idea around de-dollarization in the near to medium term should be discounted given the dollar’s deep structural foundation in the world’s financial system. For now, there simply is no alternative to the dollar.

For those who suffered through the housing crash following the 2007−09 financial crisis, it’s hard to imagine that in 2025 there would be a housing shortage.

Yet American residential investment, which stands at 3.3% of gross domestic product, remains tepid at best amid an affordability crisis that will not be solved anytime soon. 

Because of an enduring supply problem, the cost of housing is increasing at a 4% yearly rate within the consumer price index, and that rate is half the 8% yearly rate in 2023.

U.S. housing starts for July came in at 1.43 million on an annualized basis, which only reinforces the supply side problem as mortgage rates remain elevated.

In addition, with 1.361 million units under construction and 1.34 million completions in June, it is clear that overall construction is nowhere near adequate to meet demand, even with the current 30-year fixed mortgage rate residing at 6.67%. 

Since sweeping new tariffs started to take effect this year, economists like me have been cautioning that it’s only a matter of time before those costs show up in the hard economic data.

In May, buried deep in an otherwise tame consumer price index report, the impact began to appear.

In a range of categories of goods subject to tariffs—such as steel and aluminum, which saw a 25% levy—prices increased significantly.

Consider canned vegetables. The price of that standard food item rose an outsized 2.6% on the month, serving as a reminder that many mundane products, like a can of green beans, rely on steel. 

Additional areas of the CPI report showed early signs of the tariffs’ impact.

Perishable imports like bananas and roasted coffee, which are not grown in the continental U.S., are subject to tariffs now. Banana prices rose by 3.34% on the month and roasted coffee prices by 1.8%.

To put the increase in coffee in perspective, that 1.8% translates to a $950 million increase in costs for consumer and businesses that purchase coffee. 

Steel-dependent major appliances saw a 4.3% price increase, driven by the 2.3% rise in the cost of laundry equipment.

This gain in appliance prices mirrors what happened during the 2018−2020 round of import taxes, when the cost of imported washing machines surged.

So as the initial stage of tariffs works its way through the economy, it is natural to think about inflation expectations and whether this episode will prove transitory.

In the washing machine example from a few years ago, the cost of dryers also increased, even though they were not subject to tariffs.

This time around, if inflation proves transitory, the Federal Reserve may cut its policy rate later this year.

But if consumers’ inflation expectations rise because of short-term dislocations in the price of food at home or other goods, then it’s going to be some time before the Fed cuts rates.

It’s been a few months since the U.S. imposed tariffs on Canadian imports. While the outlook on trade remains as uncertain as ever, things might not be as bleak as they seemed back in March.

Despite the imposition of a 25% tariff on all Canadian imports excluding energy products, the reality is more nuanced. A crucial point is that goods that comply with the United States-Mexico-Canada Agreement (USMCA) are exempt from tariffs.

As a result, the effective tariff rate the U.S. has on Canadian imports was only 2.3% as of April 30—the lowest of all major U.S. trading partners and one of the lowest among all countries. In April, nearly 90% of Canadian exports reached the U.S. market without incurring tariffs.

Thirty-eight percent of Canadian goods sent to the U.S. in 2024 were USMCA-compliant; that figure has since climbed to more than 50%.

Before this year, there was little incentive to go through the administrative steps to ensure USMCA compliance since noncompliant goods were exempt from tariffs under that free trade agreement. Now, businesses have a significant incentive to make their goods USMCA-compliant, as the tariff-free benefit outweighs the administrative burden.

Jobs in Canada’s trade sector saw an increase in May after a sharp decline in April, indicating that the sector has recovered after the initial shock.

If the effective tariff rate on goods from Canada and Mexico remains below 5%, demand for Canadian goods is expected to remain solid.

Canada also chose not to retaliate after the U.S. raised its global steel and aluminum tariffs to 50% in early June. This would eliminate the effects of retaliatory tariffs on Canada’s inflation rate.

At the same time, opportunities are emerging elsewhere as Canadian provinces actively remove barriers to domestic trade. One example was Ontario and Manitoba’s agreement in May to ease barriers on the flow of goods, services and workers between the two provinces.

Canadian businesses are also exploring expansion into other markets, including Europe and Asia.

Of course, there are several potential risks to monitor. A sharp downturn in the U.S. economy could lower demand for Canadian exports, new developments on trade could sour at any moment, and the ongoing conflict in the Middle East could pose a concern for the global and Canadian economies.

With these considerations in mind, the probability of a recession in Canada brought about by tariffs has markedly decreased—and the outlook is more positive now than it was a few months ago.

During the first six months of the year, the American dollar depreciated against all 14 major trading currencies as investors diversified away from risk associated with dollar-denominated assets. 

A combustible mix of trade and fiscal policies has resulted in a questioning of the safe-haven status of the greenback. By July 1, the dollar had fallen by more than 12% against the euro before recovering just a bit when policies were rearranged once again. We think the dollar will eventually trade at 1.20 against the euro, which in our estimation is a good approximation of fair value.

The policy mix out of Washington has effectively ended the dollar’s 14-year bull run as investors turn to focusing on the United States’ growing budget deficit, its reduced willingness to be the global consumer of last resort and Washington’s effort to narrow the American trade deficit. 

The recovery in equity valuations over the past month has been impressive. Driven by the United States pulling back from a multifront trade war, the S&P 500 in mid-May was essentially flat for the year after a sharp sell-off.

But the bond market is seeing something different.

Instead of yields falling as equity valuations have recovered, the fixed income market has focused on the shaky and incoherent foundation of the trade conflict, the unimpressive revenues earned from trade taxes and the growing probability that tax legislation will feature a large tax cut funded by government debt.

Given the risks to the economy—a recession is still a coin flip this year—and the recovery in the equity markets, bond yields should be falling.

They are not, and that is because fixed income investors are sniffing out the logic of embracing economic populism amid a move toward trade protectionism, a scenario that strongly implies higher inflation and rising long-term yields.

That view results in investors demanding additional compensation, also known as the risk premium, for holding U.S. Treasury securities under such conditions.

And the increase in yields is exactly what happened in the first two weeks of May.

With Congress appearing to be headed toward a large tax cut that is not paid for, and with Moody’s downgrading the U.S. credit rating, the bond market has pushed yields higher to capture this new sense of risk.

Any move above 5% at the long end of the curve will result in heightened strain in markets and have a ripple effect throughout the markets and the broader economy.

Following the downgrade of the U.S. credit rating by Moody’s from Aaa to Aa1, we expect a rising risk premium across the Treasury curve as investors digest the implications of the downgrade and the direction of fiscal policy.

Indeed, following the downgrade, yields increased all along the Treasury curve, with the 10-year breaching 4.5% and the 30-year moving above 5% in the first trading day following the announcement.

The unusual intersection of trade and fiscal policy is creating the conditions for further financial volatility that could send yields higher, the dollar lower and equity prices on a wild ride.

It appears that fiscal policy is moving toward larger deficits, which will provide a fiscal impulse of just under 1% of gross domestic product in the near term but would also add, according to the Committee for a Responsible Federal Budget, $2.9 trillion to the deficit over a 10-year period and $3.3 trillion if made permanent.

The Joint Committee on Taxation has estimated the proposals on tax cuts and spending could cost as much as $3.8 trillion over the next decade. That would add $3.3 trillion to the national debt over the full 10-year window and $5.2 trillion if made permanent.

According to the CRFB, that would add $1.8 trillion and $1.9 trillion to the budget in interest rate costs, respectively, equal to 4.2% and 4.4% of GDP. And It would result in an increase in debt as a percentage of GDP to 125% and 129% if made permanent.

In our estimation, the bond market is not buying it, and risk is asymmetrically skewed toward higher interest rates at the long end of the Treasury curve, with the 10-year and 30-year both advancing to or above 5% as investors price in elevated inflation on the back of higher tariffs and the likelihood of an unfunded tax cut.

Moreover, the more important risk is that investors will step up the pace of swapping out dollar-denominated assets for other safe havens, causing yields to rise along the entire Treasury curve. 

OPEC+ recently announced a 411,000 barrel per day increase in crude oil production targets for June, following an identical increase in May’s target.

While lower oil prices often translate to lower gasoline prices, the recent decoupling of oil and gas prices shows there’s more at play. Consider two key factors:

• OPEC+ is doing more than increasing production faster than planned. The cartel, in a departure from its usual goal of cutting output to raise prices, signaled that it is willing to drive prices lower to pressure OPEC+ members like Kazakhstan and Iraq, which have been exceeding their production quotas.
• OPEC+’s production targets still reflect only expected production. Actual production totals decreased in March as well as April, when production decreased by 200,000 barrels a day compared to the planned increase of 138,000. Only time will tell if these production increases for May and June materialize as planned, or if the threat of lower oil prices is enough to rein in the overproducing countries.

Significant uncertainty remains in oil prices, and it will be important to follow both OPEC+ and U.S. producers to see the ultimate impact.

U.S. producers will be watching global oil production and prices closely in the coming months as they plan their output for this year and beyond.

Sustained prices around $60 will most likely put many oil companies into “maintenance mode” with minimal production growth, while sustained prices below $55 are likely to drive a contraction in supply, which would have a significant effect on the energy supply chain.

RSM contributing author: David Carter, Industrials Senior Analyst, Director

The attempt by Washington to upend the global economic order has done more to dent confidence in U.S. financial assets than anything since the near collapse of the U.S. economy in 2008.

Recent financial volatility has led Washington to find a face-saving way out of a crisis of its own making. Announcements concerning the United Kingdom and China were examples of this desire to find an off-ramp from the trade war. But make no mistake: Tariffs remain historically high, even with the reductions.

Since flexible currency arrangements tend to govern the movement of capital—with notable exceptions such as China—this implies that the appreciation of currencies against the dollar to help defuse the crisis is coming.

Investors, as a result, have begun purchasing select Asian currencies ahead of that possible outcome.

State of play

Foreign investors have recently been jettisoning their holdings of U.S. Treasury bills and bonds as Washington seeks to exit the role of consumer of last resort. The dollar, in turn, has been falling compared to other major currencies.

It’s not just exporters that have benefited from the strength of the dollar and the stability of the U.S. bond market. Ostensibly, Taiwan insurance companies have decided to cut their losses by selling their unhedged investments in the U.S. Treasury market.

For years there was no reason to hedge a U.S. investment. An investment in a Treasury bond not only offered a greater return but also served as a safe haven.

Taiwan is not an exception. Fiscal policy is changing in the euro area and the UK, and monetary policy is changing in Japan, all of which is adding to the attractiveness of investing in their economies.

Many of these changes can be attributed to the geopolitical preferences of the new U.S. administration. 

Previously, not only were U.S. interest rates far more attractive than those nations’ domestic rates, but the yield pickup of a U.S. government or corporate security would be augmented by dollar strength, with the safety of the investment guaranteed by U.S. institutional strength and, in particular, the rule of law.

Japanese investors have long supported and benefited from the U.S. economy and have reciprocated with purchases of U.S. government debt and by being a trusted ally.

The former was particularly the case for the years when the Bank of Japan relied on negative interest rates to stimulate domestic growth.

But in March 2024, Japan’s negative rates were abandoned, and since then, its policy rates have slowly moved above zero. So if Japanese investors no longer have to hedge their currency exposure, and if Japan’s economy can be expected to continue growing, then a Japanese government bond looks that much more attractive and safe.

There has been talk of a replay of the 1985 Plaza Accord, which attempted to reverse the dollar’s strength. But that was a fruitless enterprise, with the currency market eventually taking control of the dollar’s value.

These recent months of strain in financial markets could very well mark the end of the U.S. century of dominance.

American consumers continued to front-run tariffs in March, with retail sales posting their strongest monthly gain since 2023.

Headline retail sales rose by 1.4% in March, matching lofty market expectations. The increase was largely fueled by strong demand for autos and construction materials—signaling a clear shift in consumer behavior as buyers moved to lock in purchases ahead of expected tariff hikes.

Crucially, the control group—which strips out volatile components like autos, gas and building materials and serves as a better proxy for gross domestic product—also showed impressive strength. 

But will that spending last?

Only 35.1% of consumers expect real income gains over the next year, continuing a decline in those expectations, according to the University of Michigan’s consumer surveys.

Consumers, after all, are expecting higher inflation, which we believe will advance by a minimum of 1% to 1.5% because of trade taxes. 

As a result, consumer perceptions on whether it’s a good time to make significant purchases are changing. Buying conditions for vehicles, houses and consumer durables all declined in March, according to the University of Michigan surveys.

In the end, these dynamics do not bode well for household spending and economic growth.

The 10-year Treasury yield has increased in recent weeks, fluctuating between 4% and 4.5%, in a sign of the pressure building across the fixed income complex as investors seek cash.

Investors, facing significant volatility, have been looking for a safe haven as global tariffs are implemented, margin calls are made and aggressive investment strategies are unwound.

Should yields continue to rise, an overleveraged hedge fund, private equity fund or private credit fund will seek a hasty liquidation as the shock unleashed by the new trade regime intensifies. 

While some have made the case that yields have spiked because foreign holders of Treasury notes have been dumping them, we would disagree.

First, the dollar has appreciated as yields have increased, making it unlikely that it is foreign holders that are dumping U.S. Treasury securities on the open market.

Second, the offshore Chinese tradable currency has hit an all-time low recently, which cannot happen without the Chinese monetary authority purchasing Treasurys to force the value of the currency unit down.

In addition, China has reduced its Treasury holdings over the past three years. It is now the second-largest foreign holder of these securities, behind Japan and just ahead of the United Kingdom. China holds 9% of total U.S. Treasury securities, while Japan holds 13%.

The Federal Reserve is the largest single holder of U.S. Treasury notes.

Finally, inflation will most likely spike in the coming weeks as the new trade regime raises the price of imports. As that reality shows up in the hard data, there is a greater chance that yields will go even higher.

In our view, such a spike could force policymakers to seek an off-ramp from the current tariff policy path, which, if allowed to continue, will tip the economy into recession this quarter.

The U.S. government’s effort to overturn the global trading system has stimulated an exit from U.S.-denominated assets, causing sustained volatility across asset classes.

As the dollar has lost value in recent weeks, the loss of confidence in the new administration’s trade policy has spread from domestic financial investors to global fiscal and monetary authorities, which appear to be selling Treasury securities and dollars. 

A tumultuous rollout of the new trading regime has undermined the confidence of safe-haven American financial assets as investors suddenly face a three-month period of uncertainty in which significant new trade taxes may or may not be imposed on goods entering the U.S.

This unusual asset pricing volatility in the S&P 500 is similar to what occurred during the 2008−09 financial crisis.

Since a new round of tariffs was imposed, and then partially paused, in early April, the S&P 500 and the dollar have both declined, reflecting a loss of confidence among investors.

At the same time, the Chicago Board Options Exchange Volatility Index, a measure of expected volatility in the S&P 500, has surged.

Financial chaos has its cost.

The cost of that turmoil is being played out in the depreciation of assets across the stock, bond and currency markets. 

Tariffs are taxes on imports that aim to limit the supply of foreign goods into a country. Their impact on prices and trade volume is no different from what a supply shock like the pandemic or the start of the war in Ukraine had on inflation and growth.

And that’s just what the United States is heading toward—another supply shock, which will spur the worst kind of inflation.

If three years were not enough for the Federal Reserve to claim victory over inflation—which is still running above the target rate even with highly restrictive interest rates—we don’t think tariff-induced inflation will be “transitory” either.

Our RSM US Supply Chain Index has already flagged weaknesses since November, staying below the neutral threshold for supply efficiency.

In addition, there are other reasons to believe that inflation will not be a one-time event, as some proponents of tariffs have suggested.

First, one of the most important goals of taxing imports on such a large scale is to generate enough revenue to pass a tax bill as early as the first half of next year.

Since tax cuts are inflationary, they would only put more pressure on inflation. A supply-driven shock followed by a demand-driven shock that spiked inflation is exactly what happened during the pandemic.

Second, the labor market is already at full employment. With tariffs followed by tax cuts, the pressure on hiring would only ramp up to fulfill domestic demand.

While more workers will be available on the market because of layoffs from the federal government, they account for only a small portion of the total labor market. That should keep wage growth elevated.

Finally, as the dollar continues to weaken—both intentionally and unintentionally—Americans' purchasing power when it comes to foreign goods will only decline further.

It is no secret that the new administration wants to weaken the dollar to increase U.S. export competitiveness while lessening the burden of interest rate payments on government debt.

Reducing the trade deficit also means reducing the flow of foreign capital into the U.S., which would depreciate the dollar even further.

The takeaway

For decades, the U.S. has benefited from a financial account surplus—positive capital inflow—that has financed its growth and its trade deficit. The recent sharp turn in trade policy will have a major impact on the flow of capital toward other regions, putting U.S. growth at higher risk.

After the pandemic, the U.S. was able to come out ahead of almost every nation because of how swiftly it addressed the inflation problem and kept growing at a robust pace while other countries struggled with inflation and growth.

But this time around, inflation will likely be a U.S. problem only, as it places tariffs of 10% or more on virtually all of its trade partners. 

U.S. Treasury Secretary Scott Bessent recently said that he was focused on the real economy and was not concerned about a little market volatility.

We agree.

Whenever and wherever possible, it’s a good idea to look at real economy indicators. A focus on the intersection of the real economy and financial markets is even better.

That is why many economists and investors tend to favor transportation indicators when trying to understand the direction of aggregate demand.

One of our favorite coincident indicators is the Dow Jones U.S. Trucking Index, which in mid-March had declined by more than a quarter from its peak on Nov. 11. 

The recent market volatility, which has been spurred by policy uncertainty around trade and tariffs, may be stomach-churning but is not sufficiently large to tip the economy into recession.

Instead, we think that the economy is experiencing a late-cycle slowdown and that growth should ease to at or below 1.5% in the current quarter.

The combination of easing demand and financial market volatility has caused us to lift our probability of a recession to 20% over the next 12 months, up from 15% at the start of the year.

But should demand for goods ease further, a broader bout of risk aversion will dampen outlays on capital expenditures, hiring and durable goods subject to import taxes.

Transportation and trucking indexes would likely capture that shift in near real time, and we would have to revisit our growth forecast for this year. 

For the most part, the current multifront trade war has been more sound than fury.

But now, the 25% levy on steel and aluminum products has taken effect, spurring retaliation from Canada and Europe.

The spot price of 5.5-inch-diameter North American steel pipe, which has soared more than 30% over the past month, is a sign of the cost increases to come.

Those pipes are used by drillers to extract oil from the ground.

Given falling oil prices since the middle of January and the rising cost of materials, the break-even price of oil for producers is increasing.

Euro area government bond yields have been rising since the start of the year. As of March 13, they were up by 51 basis points.

This rise is because of global policy changes that could bring large structural shifts in trade and financial flows.

These changes will in turn most likely strengthen the yen and euro in the near term as policy uncertainty in the U.S., slower growth and the possibility of a widening trade war lead to capital flows seeking to profit from those changes. 

Interest rates in Germany in particular seem poised to move higher considering calls by the incoming chancellor, Friedrich Merz, for a significant increase in military and infrastructure spending that should kick-start an otherwise moribund economy.

Japanese government bonds are 42 basis points higher as inflation and growth finally come to the Japanese economy, allowing the monetary authorities to raise short-term interest rates above zero.

This has all occurred within a short time span, when growing concerns about the U.S. economy have pushed U.S. 10-year Treasury bond yields 27 basis points lower since the start of the year.

The upshot is that diminished yield spreads are offering less support for the dollar against the euro and yen. 

The dollar’s recent five-month appreciation versus the euro appears to have topped out, reversing the dollar’s move toward parity. The euro is now trading above 1.09.

The yen, which was trading at 157 at the end of last year, has appreciated to 148 against the dollar, with 10-year yields above 1.5% in the second week of March.

We expect Japan’s monetary authority to continue to push its policy rate higher, allowing interest rates to normalize during this latest episode of increased growth and rising prices.

Recent trading suggests that the dollar, although still strong, appears to be more vulnerable than it has been over the past two to three years.

The consensus among traders is that the certainty regarding the U.S. economy and the dollar has been replaced by uncertainty.

One way to understand the financial impact of policy uncertainty is to look at the implied volatility of important currency pairs in option prices.

This dynamic is seen in a curve known as the dollar volatility smile, which shows how the American dollar can strengthen against another currency based on economic performance.

The curve captures the status of the U.S. dollar as the primary international reserve currency as well as the relative strength of the U.S. economy compared with its major trading partners.

Under this framework, during times of global economic disruption, investors seek the safe haven of the greenback, and capital flows into dollar-denominated assets. A robust American economy attracts global capital, bolstering demand for the dollar and causing it to appreciate.

But during times of stagnant growth, the dollar depreciates, which causes an outflow of capital in search of greater returns around the globe.

With 25% tariffs on Canadian and Mexican imports set to kick in on April 2 as well as 20% on Chinese-produced goods, expect the curve to slope upward. 

By March 3, in the month before the announcement of higher trade taxes, the implied volatility strongly suggested that the U.S. dollar/Canadian dollar currency pair showed robust demand for protection against a rising dollar.

The U.S. dollar strength was attributed to interest rate differentials as well as to the hit that will be absorbed by Canada, where 25% of its gross domestic product is dependent on trade with the U.S.

Investors and corporations seeking to hedge against potential tariffs sought out such protection through global financial markets.

As of the last week of March, the more gently upward-sloping curve implies what will be a moderation of dollar strength versus the loonie, with the market now factoring in the potential of higher U.S. inflation and diminished U.S. growth.

In the wake of the emergency defense summit in Paris in February, a large increase in defense spending among European Union nations appears likely.

That outlay may be as large as $3.1 trillion over the next decade, Bloomberg reported.

Any such move will affect foreign exchange and bond yields (both recently falling) as well as oil, energy and natural gas markets as the European continent reindustrializes.

Such a shift in spending would represent a major change in global finance, including the possibility of large-scale issuance of joint European debt. Such a rise in issuance would have serious implications for the global banking industry and the European Central Bank.

What’s more, the scenario under discussion would almost certainly preclude the return of natural gas imports from Russia. Continuing this cutoff would stimulate shipbuilding to transport natural gas from the U.S. and elsewhere to provide energy to Germany, the heart of European manufacturing.

Already, the prospect of higher defense spending has boosted the share price of Rheinmetall, a German automotive, defense, electronics and engineering firm that has an American subsidiary, American Rheinmetall, in Sterling Heights, Michigan. Rheinmetall is among the defense firms across Europe and the UK whose valuations increased in the wake of the defense summit.

One category of manufacturer that would benefit from significantly higher defense outlays is the Mittelstand, the small and medium-sized firms that represent the majority of German domestic firms. 

In the end, a common EU defense buildup would provide substantial relief to many manufacturers, particularly in Germany, which has been caught in a deindustrialization trap as China has flooded global markets with cheap alternative vehicles and other goods. 

The federal government continues to issue significant amounts of debt, much of which will be purchased by foreign investors.

Despite predictions that such interest among foreign investors would wane, the United States remains a magnet for foreign capital.

And it’s likely to continue, as growth and interest rate differentials, a strong dollar and the purchase of dollar-denominated assets continue to support foreign purchases of American debt despite rising U.S. deficits.

Through the end of November, the largest foreign holders of U.S. debt were Japan at $1.09 trillion, China at $768 billion and the UK at $765 billion.

Since 2019, China’s holdings of U.S. debt have declined by 31.8%, while Japan’s have increased by 3.2% and the UK’s have soared by 163.9%.

The Federal Reserve, with $4.274 trillion on its balance sheet, is the largest holder of American debt.

That debt will, however, be bought with a rising risk premium, making it more expensive for the federal government to continue down the path it is on.

Given the fiscal expansionary policies that are being put in place, these factors will play an increasingly important role in the economic and financial narrative over the next few years. 

For the first time since the dot-com bust in 2001, the difference between the equity earnings yield on the forward-looking S&P 500 and the yield on the 10-year Treasury has declined into negative terrain.

This is a function of the high concentration of the biggest technology names within the S&P 500 and is a risk that may grow along with the uncertainty caused by policy shifts of the federal government. 

In our economic forecast for 2025 we indicated that froth in financial markets is one of the risks to the economic outlook this year.

That risk is attributable to the exposure of the upper two quintiles of income earners to equity valuations. This cohort is responsible for over 60% of all consumption—think of the robust 4.2% increase in U.S. household spending in the fourth quarter and what is driving it.

A sustained decline across domestic equity markets in general and a drop in technology valuations in particular would almost certainly cause a pullback in household spending.

Given the increase in policy uncertainty and its clear link to volatility across asset classes, this concentration risk is something that demands close attention. 

It’s no mystery that rising uncertainty over the new administration’s policies is one of the major risks to financial markets and the economic outlook.

Volatility across asset markets has been rising as investors adjust to changes in fiscal, trade and financial policies, measures of volatility show.

Volatility will be evident in equity valuations; long-term bond yields, which have risen despite rate cuts by the Federal Reserve; and global currency markets, where currencies have been depreciating against the U.S. dollar.

In addition, U.S. firms and households will pull spending forward ahead of the expected rate shock that will accompany a new round of tariffs.

Policy shifts with a new administration are not new. What is new, however, is the scale of the uncertainty this time around, and that is extracting a tax across financial markets.

It begs a larger question: Will the volatility in financial markets spill into the real economy, causing firms to pull back on critical investments and households to reduce spending?

In recent months, emerging market currencies have been depreciating against the U.S. dollar. Differentials in growth, interest rates and expectations of policy changes by the Trump administration are all contributing to the decline.

Whether the depreciation is taking place in economies that have currency pegs, like China; in countries exiting pegs, like India; or in those with flexible exchange rates, like Brazil, clearly this year will be one of adjustment to more aggressive trade policies in the U.S.

One difference between a trade skirmish and a trade war is the type of beggar-thy-neighbor currency depreciation that typically follows tit-for-tat increases in tariffs.

Economies with inadequate capital buffers, economic imbalances featuring large import volumes or weak financial systems will be at risk of greater-than-anticipated currency depreciation.

Given the focus on the export of goods by Chinese-owned firms, it follows that the emphasis this year will be on those economies, mostly in Asia, with substantial investment by Beijing.

In particular, the emphasis in other countries on transshipments of lower-value-added goods, mostly from Chinese-owned firms, means that global investors should anticipate that currency valuations in emerging markets will face further volatility.

The new administration announced a new round of import taxes on a variety of goods across several economies including Canada, Mexico and China.

It is not too early to begin estimating the resulting deadweight on economic activity.

The import taxes will have an impact on supply chains and, in turn, put upward pressure on durable goods prices, which was the primary driver of inflation during the pandemic and its aftermath. 

The Federal Reserve Bank of New York’s global supply chain pressure index strongly implies there is a link between disruptions to the flow of trade and inflation of durable goods.

A focus on imports that come directly from China and an attempt to address transshipments of Chinese-made goods through other countries will increase supply chain pressures and raise the cost of durable goods.

Please check back for RSM’s economics insights as detailed information on changes in trade and financial policies becomes available and we model shocks to the U.S. and global economies.

The American public expressed its preference for reduced immigration in electing President Donald Trump to a second term.

Yet underlying demographic realities show that this preference stands at cross-purposes with the needs of the U.S. economy. 

In a recent report, the Congressional Budget Office increased its estimate of population growth for this year to 350 million from 346 million.

But it revised down its estimate for 2054 to 372 million, which implies a growth rate over the next 30 years of 6.3% compared to the 10.5% that it had previously forecast.

Based on these estimates, the decision to slow or severely limit immigration and increase deportations will affect growth, employment, wages and inflation in ways that have not been experienced in the past 20 years.

The CBO report points to near-term risks to population growth, estimating that growth will slow from an average of 0.4% per year over the next decade to 0.1% from 2036 to 2055.

Without immigration, the U.S. population would shrink beginning in 2033 because reproduction by the native-born population would be too low to offset the mortality rate of the baby-boom generation.

An economy currently characterized by higher inflation, higher interest rates and a relatively tight labor market would face additional labor constraints—especially if deportations increase significantly. A shrinking labor supply would drive lower unemployment, higher wages, higher inflation and, ultimately, slower economic growth.

The administration’s strategic economic objective is to rebalance the global economy.

That is, the Trump administration intends to reverse the substitution of more expensive domestic manufacturing with cheaper foreign production, with the goal of narrowing the prodigious U.S. trade and current account deficits. 

But that objective stands in contrast with a macroeconomic policy mix that will most likely result in the opposite taking place.

That is, government-financed tax cuts and increased spending will put more cash in the hands of firms and households, which will increase spending and aggregate demand. That demand will create the conditions for rising yields as public and private actors chase scarce capital, causing the dollar to appreciate.

All of this will cause the trade and current account deficits to widen, not narrow.

This is why the administration is so focused on imposing tariffs, which are the symbolic heart of the administration’s efforts to rebalance the global economy.

But that is not how financial markets are likely to behave with respect to valuation of the dollar and the setting of interest rates.

Instead, the way to narrow the trade and current account deficits is through fiscal consolidation, featuring higher taxes and reductions in government spending.

That approach would promote a weaker dollar as a complement to a selective tariff policy. But that approach is clearly not on the agenda for this administration.

Given the basic inconsistency inside this economic framework, something has to give over time.

Under Trump’s policy framework—which we think will be implemented—the administration will be forced to consider either far higher tariffs than those being discussed or turn to devaluing the dollar, something the president and Treasury Secretary Scott Bessent have said they do not support.

Or, the administration will have to consider taxing the purchase of U.S. government securities by foreign entities, which would drive up yields.

This administration is not the first nor will it be the last to have a set of contradictory economic policies and objectives.

The extent to which it achieves a synthesis might be determined by the financial markets. If the internal contradictions of the policy framework are not resolved, the bond market will push yields higher, and the markets will become the ultimate arbiter of whether the policies succeed or fail.