Tariff Term Premium

Manhattan is getting “tariffed” at the gate with $9. It is a good example of a localized universal tariff.

While it has no bearing on markets, even though NY Harbor Gas futures are at their highest since October due to blizzard temperatures (which is not deterring traffic!), the market is focused on the Wapo tariff story, which is already causing a fissure, with Trump denying the story.

Tariffs are priced into currencies and inflation-linked securities and expressed in extra compensation, the term premium, for holding longer-term bonds. Bill Dudley’s observations that the term premium has been a driver of the rise in yields can be dissected by what the bond market calculates as "tariff term premium."

Universal tariffs are expected to shock consumer prices. The inflation market is discounting a sudden price rise that could reverberate for several months to even years, not just in the US but globally.

For example, inflation expectations for the next 1 to 18 months rise to 2.5%, with a choppy, volatile pattern in the years following (see Figure 1). The chart displays the difference between the forward curve for Treasuries and TIPS.

Bonds are discounting this risk of fluctuating CPI with additional premiums. Tariffs are reflected explicitly in the difference between the 1Y and 10Y inflation swap, which has seen a strengthening relationship with the term premium (Figure 2).

What bonds are ‘saying’ is that tariffs being inflationary may not solve the enormous fiscal deficit. Inflation causes spending retrenchment and potential weakness in growth and employment. However, tariffs also have deflationary impacts, as seen in China.

Figure 1: Inflation expectations for the next 18 months (in bps taken from TIPS and Treasury forward curves)

Source: Bloomberg FWCM

Figure 2: Term premium and tariff premium (%)

Source: CME, NY Federal Reserve

The term premium in China has been falling as its yield curve is flattening. Conversely, rising term premiums have steeped the US yield curve (bearish). This is likely due to expectations about tariffs: inflationary for the US and deflationary for China.

China may fall into negative yields, an environment where long-duration assets flourish. The 30Y Chinese bond is already trading below the yield of Japanese bonds. But where the prospect of negative yields has yet to be priced or anticipated are Chinese Tech shares.

The Chinese Tech ETF, CQQQ, has lagged the large-cap ETF, FXI, and CQQQ pays just a 0.29% dividend yield. That means the duration of Chinese Tech stocks is 344 years (!), the inverse of the dividend yield (1/0.29%). That compares to the US tech stock duration, which averages 55 years.

So, as tariffs get implemented, Chinese Tech stocks have scope to perform as Chinese bond yields edge to negative territory.

Tariffs are a risk and opportunity, as Trump's trade policy levitates divergence across global assets, creating winners and losers. Such an environment may cause choppy price action, but the direction is clear: yields and currencies are pricing tariffs favorable for US growth but unfavorable for the global economy.

Regards,

Ben

Figure 3: Chinese yield curve versus the US yield curve (bps)

Source: Tradeweb, BlackRock

Figure 4: Chinese Tech ‘lagging’ (normalized scale)

Source: iShares, Invesco