Market sentiment shifts sharply: Trump trade becomes recession trade?

Bond traders are signaling a growing risk of a U.S. economic shutdown given Trump’s chaotic tariff policies and federal government layoffs.

Less than two months into Trump's presidency, speculation that he would inject stimulus into the U.S. economic expansion and keep upward pressure on Treasury yields is quickly being forgotten. Instead, traders have been buying short-term Treasury bonds in droves, with two-year yields falling sharply since mid-February on expectations that the Federal Reserve could resume cutting interest rates as early as June to prevent the economy from deteriorating.

“Just a few weeks ago, we were being asked if we thought the U.S. economy would reaccelerate — and now, all of a sudden, the word ‘recession’ is being mentioned over and over again,” said Gennadiy Goldberg, head of U.S. rates strategy at TD Securities, referring to the risk of a recession. “The market has gone from optimism about growth to outright despair.”

The change marks an abrupt reversal for the Treasury market, which has been driven primarily over the past few years by the surprising resilience of the U.S. economy even as growth abroad has slowed. Investors’ initial bets on the outcome of the presidential election only exacerbated that trend, sending Treasury yields sharply higher late last year on expectations of faster growth and higher inflation — a pillar of the so-called “Trump trade.”

However, since mid-February, as the new administration's policies have brought great uncertainty to the economic outlook, U.S. Treasury yields have begun to fall, with short-term bonds leading the decline, making the yield curve steeper, which usually occurs when investors expect the Federal Reserve to begin easing monetary policy to stimulate economic growth.

A key driver is Trump’s brewing trade war, which is likely to deliver another inflationary shock and disrupt global supply chains. Stocks sold off last week as a result, and the sell-off continued even after Trump again delayed tariff increases on Mexico and Canada. The government’s move to freeze federal funds and lay off tens of thousands of government workers also had a negative impact.

“The risk of a recession is definitely higher because of the sequencing of Trump’s policies — tariffs first, tax cuts later,” said Tracy Chen, portfolio manager at Brandywine Global Investment Management.

Trump said on Sunday that the U.S. economy faces "a period of transition," responding to concerns about the risk of a slowdown. U.S. Treasury prices rose during Asian trading on Monday, with the benchmark 10-year Treasury yield falling below 4.27% at one point.

The shift in sentiment was highlighted last week by a divergence between European and U.S. bond markets, which typically move in tandem. Yet while German bond yields surged on expectations of higher defense spending to make up for reduced U.S. support for Ukraine, U.S. Treasury yields barely budged.

Of course, bond traders have braced for a possible recession several times over the past few years, only to be thwarted each time as the economy continued to move forward . Moreover, the three 25 basis point rate cuts they currently expect from the Fed this year are not enough to indicate that the Fed will enter recession-fighting mode . On Friday, Fed Chairman Jerome Powell said he was in no hurry to resume accommodative policy, saying that "although uncertainty is high, the economy remains in a good place."

Additionally, inflation is likely to continue to put upward pressure on yields , with this week's Consumer Price Index (CPI) report expected to show that prices rose 2.9% year-on-year in February, still above the Fed's 2% target.

However, signs that the economy is cooling are also accumulating, including the Atlanta Fed's GDPNow indicator, which showed that U.S. gross domestic product (GDP) may have contracted in the first quarter.

While the Labor Department reported that job gains were sustained in February, its report on Friday also provided evidence that the labor market is softening, including more permanent job losses, a decline in federal government employees and a surge in the number of people working part-time for economic reasons.

Edward Harrison, MLIV strategist at Bloomberg, noted, “ The details of the (employment) report show much worse , and the forward-looking aspects of the report appear to have driven the continued rise in U.S. Treasury prices. These data support the Fed’s early rate cuts and exacerbate market concerns about a recession, so they should continue to drive the recent trend of a bull market in bonds and a bear market in stocks in U.S. financial markets.”

The direction of the Treasury market will depend largely on how Trump's policies are implemented in the coming months. U.S. Treasury Secretary Scott Bessent acknowledged on Friday that the economy could see some turbulence due to the administration's policies, but he expressed confidence in the economy's long-term prospects.

On Thursday, Trump appeared to respond to some concerns about the administration’s aggressive cost-cutting efforts by instructing Cabinet secretaries to use a “scalpel” rather than an “axe” when it comes to job cuts. He also delayed a second tariff increase on Mexico and Canada by a month as the stock market plunged.

“Before this trade war, the market thought tariffs would cause inflation, and now people think tariffs will cause a recession,” said Chen of Brandywine Global Investment Management. “So it’s a huge shift.”