Markets have reacted positively to the U.S.-China détente in
tariffs. Our Chief Fixed Income Strategist, Vishy Tirupattur,
digs into the rallies to better understand potential longer-term
outcomes.
Read more insights from Morgan Stanley.
----- Transcript -----
Vishy Tirupattur: Welcome to Thoughts on
the Market. I am Vishy Tirupattur, Morgan Stanley's Chief Fixed
Income Strategist. Today I'll talk about the impact of last
week's 90-day pause in the reciprocal tariffs between the U.S.
and China, and the impact on the economy and markets.
It's Monday, May 19th at 11am in New York.
Market response to last Monday's announcement has been
resoundingly positive. The S&P 500 was up 4.5 percent in the
first four days since the announcement and the year-to-date
returns are back in the black after Liberation Day drove steep
declines in April.
Credit markets have also rallied, notably with the investment
grade spreads tightening by over 10 basis points and high yield
spreads by over 50 basis points. And the Treasury market took out
50 basis points of rate cuts in 2025, leaving market implied rate
cuts by the end of 2026 at around 100 basis points.
While these moves across markets are significant, it is really
important to put them into perspective and tease out what this
detente in trade tensions implies. And more importantly, what it
does not imply.
On the positive side, we think that the de-escalation reduces the
risk of a sudden stop in trade volumes and a sharp rise in
unemployment rate. While this is clearly just a truce and we
don't know exactly where the tariffs between the two largest
economies in the world will end up, it seems reasonable to infer
that tariffs in the vicinity of 125 percent or 145 percent are
substantially less likely now. Overall, the probability of a U.S.
recession, therefore, has fallen on the margin.
To be clear, a recession during 2025 was never really our base
case. But the de-escalation shifts risks in the direction of a
little more growth, a little less inflation, and keeps
unemployment rate at near current levels. If the world before
Liberation Day was bimodal and close to a coin toss; it is still
bimodal, but skewed towards an expansion, not contraction. Since
we were in the expansion mode to begin with, this detente gives
us greater comfort in our baseline outlook and strengthens our
conviction that the Fed will remain on hold for rest of the year.
The positive vibes from Geneva not withstanding, we would stress
that it is far from clear that the 90-day pause is an uncertainty
clearing event. Trade tensions are likely to remain elevated. The
administration is still investigating tariffs on pharmaceuticals,
semiconductors, copper, and other products. It is also unclear if
the template of negotiations between the U.S. and China can work
for other regions, especially Europe. Even if U.S. tariffs on
imports from China and the rest of the world end up roughly
around the current levels, they would still be about four times
higher than the levels at the start of the year.
This means inflation should continue to move higher into year
end, with the surge that peaks in the third quarter. While the
impulse inflation from tariffs is likely to be smaller, it still
is coming. Likewise, higher tariffs will dampen growth even
though recession will continue to be avoided.
For risk markets, we think that the detente has reduced the risk
of substantial drawdowns. While policy uncertainty about the
ultimate level of tariff remains, a return to last month’s
mind-boggling volatility driven by trade policy is probably
behind us. So, it's unlikely that we will see markets revisiting
the lows of April in the near term.
For credit markets, a lower likelihood of recession is indeed
welcome news, especially considering the current strong credit
fundamentals. With the market taking out a couple of rate cuts,
the all in yields for credit remain in the range to sustain the
demand for yield buyers such as insurance companies.
Thanks for listening. If you enjoy the show, leave us a review
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