Market Minutes

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.