Bonds: 2025 Rally Under Threat From Sticky Inflation, Potential Tariffs

Several risk factors that could end the bond market’s party, but for the moment US fixed-income markets are having a good year so far, based on prices through Thursday’s close (Jan. 30).

Using a set of ETFs to profile the various slices of US bonds, assets are posting solid recoveries after a challenging 2024.

Leading the field higher: a US junk bond ETF (JNK), which is up 1.6% year to date, more than twice the gain for US investment-grade bond benchmark via Vanguard Total Bond Market (BND).

US Bonds ETF Performance

Bonds overall are up so far this year. The strongest performers after junk: inflation-indexed Treasuries (TIP) and long-maturity Treasuries (TLT).

Although it’s been a good year so far for fixed-income investing, there are several risks lurking that deserve close attention. Two words sum up the potential headwinds in the immediate future: inflation and tariffs — risks, it appears, that the bond market appears to be downplaying.

Sticky inflation has recently been a headache for the Federal Reserve, which left interest rates unchanged this week. Progress on bringing inflation back to the Fed’s 2% target has stalled, persuading the central bank to pause on rate cuts. “We feel like we don’t need to be in a hurry to make any adjustments,” Fed chairman Jerome Powell said on Wednesday.

One of the reasons why the Fed started cutting rates last year: expectations that the labor market was weakening, if only on the margins. The pivot from focusing on reducing inflation (via rate hikes and then holding rates steady) shifted to easing policy to support softer labor market conditions. But as of Wednesday’s Fed meeting, that pivot appears to be on hold.

Comments earlier this month by Fed governor Chris Waller suggest a change in plans: “I have seen nothing in the data or forecasts that suggests the labor market will dramatically weaken over coming months,” he said in a speech on Jan. 8. “With regard to inflation, after a period of rapid disinflation in 2022 and 2023, progress appears to have stalled in the final months of 2024.”

The Fed, as a result, is in a holding pattern, waiting to see if labor market weakness or stubborn (or rising) inflation is the bigger concern. Muddying the waters are plans by President Trump to impose new import tariffs on Canada, Mexico and other countries.

Speaking to reporters on Thursday, Trump said he will impose 25% tariffs on imports from Mexico and Canada starting Feb. 1, although he added that oil imports may be excluded.

Many economists predict that higher tariffs could raise inflation. The timing is problematic for the Fed, which is still struggling to fully tame the pandemic-related price shock.

But while its obvious that raising tariffs automatically rises prices, there’s room for debate (maybe) about the effect on inflation. The Economist notes:

A one-off increase in prices might create only a short-term pop in inflation, not a sustained rise. Tariffs erode consumers’ overall spending power, and falling consumption of things produced at home creates offsetting disinflation over time. Yet there is at least a danger that a one-off shock would set off an upwards spiral of prices and wages. After several years of high inflation, such a risk is now more pronounced.

As for bonds, the longer that inflation remains sticky, or accelerates, that’s bad news. For the moment, however, the bond market is enjoying some relief after a sharp run higher in Treasury yields from September through mid-January. In the last couple of weeks, however, yields have pulled back – the 10-year yield fell to 4.52% yesterday (the lowest in over a month). The safe-haven trade appears to have overwhelmed the inflation-risk trade, at least for now.

The uncertainty hanging over the bond market now is the Trump factor vis-à-vis tariffs. Will he raise import duties? If so, by how much? How will tariffs affect inflation and Fed policy? Or, is it all a negotiating tactic?

Since it’s all about Trump, no one really has a good sense of what happens next. But at least one question resonates loud and clear: Is this the calm before the storm for bonds?