I have been reticent about the 2-year yield dropping much surrounding the trade war because I wasn’t sure how the Fed would approach its higher inflation. Three things happened yesterday to bring me around to joining the rally (yields lower) in the 2-year.

First, North American tariffs were enacted after a month of wondering if Trump would soften them. This will have an enormous negative effect on demand from higher prices. I think that Trump is primarily interested in the revenue of tariffs, and they aren’t going to go away. I also think the administration knows this (w/DOGE cost cutting efforts) will cause a recession, and that it is better to get it out of the way as soon as possible. The Wall Street Journal is running around with their hair on fire trying to warn the administration is going to damage the economy, but I think they are well aware. If it is time to have a recession anyway, why not move it as close to the start of the administration, take the approval rating hit when no elections are at risk, use it to justify tax cut extensions down the road, and be in a recovery by the mid-terms. Trump and Musk have said that there will be initial pain from what they are doing.

Second, Alberto Musalem, president of the St. Louis Federal Reserve, gave a pivotal speech yesterday, in which he reasoned that the Federal reserve could “look-through” high inflation and short-term inflation expectations if longer-term inflation expectations remained anchored. He said,

Recently, the possible effects of higher tariffs or changes in immigration policies have been widely discussed and thought likely to raise prices and soften aggregate demand and employment, at least in the near term. From the standpoint of monetary policy, it could be appropriate to ignore, or “look through,” an increase in the price level if the impact on inflation is expected to be brief and limited, or if there is meaningful trade retaliation from other countries.

Supporting this idea, 5year/5-year forward inflation expectations (longer-term) have taken a nearly 20 basis point dive since last Thursday when North-American tariffs were re-affirmed from President Trump. See red oval in chart below:

Third, the ISM report yesterday showed that negative economic data is more than just a January phenomenon. This was the first top-tier report from February and while the headline number didn’t fall much from before (50.3 from 50.9), the new orders and employment categories fell significantly, retracing a good amount of the August through January economic mini-boom.

New orders, 68% retracement of recent boom:

Employment, 40% retracement of recent boom:

I expect economic data to get weaker as tariffs take hold. As the issue broadens out to the labor market, the Fed will cut rates. As I wrote yesterday in “1990 Holds an Important Lesson for Now”, I think the trade war will serve as the catalyst for a recession amid a fully recession-primed economy.