Two-year yields fall on trade war anxiety

US two-year yields declined Tuesday as a record US trade deficit and a slew of downbeat corporate outlook statements trained investor attention on the potential for a global trade war to cause economic hardship.

More sensitive than longer-maturity tenors to interest-rate moves by the Federal Reserve, Treasury two-year yields declined nearly four basis points. Traders are pricing in three quarter-point cuts by the Fed this year, with the first one expected in September. 

“Behind the mood is the nagging fear that bad news for the economy won’t be met by any shift from the Trump administration on policy or from the Fed on easing,” said Bob Savage, head of markets macro strategy at BNY. “Good news has been insufficient to offset growth and inflation fears. Markets remain cloudy and reflect a dampening of risk appetites everywhere.”

Fed policymakers start their third meeting of the year Tuesday, and are expected to leave their target range for the federal funds rate at 4.25%-4.5% in the decision to be announced Wednesday. The market-implied expectation for rate cuts declined last week after April employment data released Friday was stronger than economists anticipated.

Fed officials in recent weeks — including Chair Jerome Powell, who’ll discuss the decision in a news conference — have mostly emphasized a need to wait and see how trade policies implemented last month affect the economy. President Donald Trump has been ratcheting up pressure on the Fed to resume cutting rates following three moves at the end of last year. 

The US trade deficit widened 14% to a record $140.5 billion in March, exceeding economist estimates, as companies rushed to import products as the Trump administration readied sweeping tariffs. It’s expected to narrow, with survey data and a drop in container shipping from China to the US suggesting the import surge is drawing to a close.

“We expect a supply-driven contraction in U.S. activity this year,” wrote BlackRock Investment Institute strategists led by Jean Boivin and Wei Li, adding that they expect tariffs to create production bottlenecks akin to the pandemic. “That presents the Fed with a sharper trade-off between protecting growth by coming to the rescue with rate cuts and reining in inflation.”

The Trump administration’s tariff’s agenda also has stoked fears about foreign demand for US assets including Treasuries, with implications for an auction of new 10-year notes at 1 p.m. New York time. While a sale of three-year notes on Monday drew strong demand, the 10-year is more critical for showing “the implications from the trade war,” interest-rate strategists at BMO Capital Markets said in weekly research published May 2. 

They expect good demand from both domestic and overseas investors, maintaining “it is still too early in the trade war to expect a meaningful rotation away from Treasuries as a reserve asset – at least not on the part of official money.”