As financial markets digest the news of Trump’s new tariffs on imports from Mexico, Canada, and China, another alarm bell is ringing: the U.S. bond market. In particular, the Treasury yield curve, long regarded as one of the most reliable predictors of economic downturns, is flashing a warning that policymakers and investors cannot afford to ignore. While markets may initially focus on the near-term fallout from this new trade war, the deeper concern lies in how these policies will interact with an already precarious economic landscape - one where rising bond yields, sticky inflation, a slowing economy, and tightening credit conditions could set the stage for a recession in 2025 or 2026.

The Bond Market’s Warning

Financial markets function as a real-time barometer of economic expectations. The bond market, in particular, reflects investor sentiment about future inflation, growth, and monetary policy. Currently, the yield curve has un-inverted, meaning long-term interest rates have risen above short-term rates. While some might see this as a sign of normalization, history suggests otherwise. Recessions typically follow after the yield curve un-inverts, rather than during the inversion itself. The reason? The damage inflicted by prior tight monetary conditions and high borrowing costs takes time to manifest in the real economy.

The Federal Reserve’s past rate hikes are still working their way through the system, keeping credit expensive for businesses and households. Now, with long-term yields rising due to increased government borrowing and inflation concerns, we face a scenario where higher rates persist—precisely at a time when economic growth is showing signs of slowing. The latest Q4 GDP report confirmed this trend: the economy grew at a 2.3% annualized pace, below expectations of 2.5% and a clear slowdown from 3.1% in the third quarter.

Trump’s Tariffs: Fueling Inflation, Suppressing Growth

Adding to these structural concerns, the Trump administration has reignited a trade war by imposing a 25% tariff on all imports from Mexico and most goods from Canada, alongside an additional 10% tariff on Chinese imports. The rationale, according to the administration, is to curb illegal immigration and drug trafficking. Yet, from an economic perspective, these measures have the effect of raising costs for American consumers and businesses while inviting retaliatory measures from key trading partners.

Canada and Mexico have already responded in kind, announcing their own tariffs on U.S. goods. China, meanwhile, is filing a complaint with the World Trade Organization while threatening further countermeasures. The economic impact of these actions cannot be overstated. In 2023, Mexico became the United States’ largest trading partner, overtaking China. A disruption in trade flows with Mexico and Canada, which together account for over 40% of U.S. exports, will hurt American manufacturers, farmers, and consumers alike.

At the same time, the tariffs threaten to undermine the U.S. dollar’s global standing. As trade partners seek alternatives to avoid U.S. economic pressure, there has been a noticeable shift toward yuan-based trade settlements and other regional currency discussions. While the dollar remains dominant, the erosion of its role in global trade and central bank reserves could have longer-term consequences for U.S. borrowing costs and economic stability.

The Fed’s Stance: Navigating Uncertainty Amidst Trade Wars

The FOMC’s latest statement underscores a commitment to bringing inflation down while acknowledging uncertainty in the economic outlook. The Fed opted to keep rates steady at 4.25%-4.5%, emphasizing that risks to employment and inflation are “roughly in balance.” However, its continued balance sheet reduction and reluctance to cut rates signal that financial conditions may remain tight for the foreseeable future.

In this environment, the Fed’s hesitation to ease policy could amplify the economic drag of tariffs and rising bond yields, making it harder for businesses and households to access affordable credit. Markets now face a delicate balancing act: while trade tensions escalate and growth slows, the Fed appears unwilling to provide near-term relief, effectively reinforcing the restrictive financial conditions already in play.

The Recessionary Mechanism: Higher Costs, Tighter Credit, Weakening Growth

The intersection of rising bond yields and escalating trade tensions is particularly worrisome. Tariffs act as a tax on imported goods, leading to higher prices for essential consumer products, from automobiles to electronics to fresh produce. Given that inflation remains above the Federal Reserve’s 2% target, these added cost pressures make it harder for the Fed to justify rate cuts, despite slowing economic growth.

This creates a negative feedback loop:

  1. Higher tariffs → higher consumer prices → reduced purchasing power.
  2. Higher bond yields → more expensive mortgages, auto loans, and corporate debt.
  3. Weaker business confidence → lower capital investment and hiring.
  4. Retaliatory tariffs → reduced export demand → weaker U.S. manufacturing and agriculture.
  5. Fed hesitancy to cut rates → prolonged period of restrictive monetary policy.

Together, these forces threaten to push the economy into a period of stagflation—a mix of sluggish growth and persistently high inflation—precisely the outcome policymakers should seek to avoid.

Markets Already Reacting

Financial markets have not been slow to register these risks. The bond market has experienced a major move over the last ~60 days, and is now demanding a higher term premium, meaning investors want greater compensation for holding long-term government debt. This reflects mounting concerns that the U.S. will need to issue even more bonds to fund expanding budget deficits—estimated to grow from $1.9 trillion in 2025 to $2.7 trillion by 2035.

The Path Forward: Averting a Self-Inflicted Crisis

While the current dynamics are concerning, the trend toward a recessionary environment is not yet irreversible. There are potential avenues to mitigate the risks:

  1. Revisiting Tariff Policies: A more strategic, targeted approach—rather than blanket tariffs—could help achieve policy objectives without excessively distorting trade flows.
  2. Fiscal Discipline: Given the upward trajectory of U.S. debt, addressing long-term spending imbalances would help ease pressure on bond yields.
  3. Monetary Policy Flexibility: The Federal Reserve must strike a delicate balance between combating inflation and ensuring credit conditions do not tighten excessively.
  4. Global Cooperation: Avoiding an escalating trade war with allies will be crucial in maintaining economic stability. The retaliatory measures from Mexico and Canada signal that a more confrontational approach risks inflicting unnecessary economic pain.

Conclusion: A Crucial Inflection Point

The U.S. economy stands at a critical juncture. The combination of rising long-term yields, inflationary tariffs, a slowing economy, and growing doubts about economic stability presents a cocktail of risks that could tilt the economy into recession. Avoiding that outcome will require a shift toward policies that prioritize economic stability over politically motivated economic nationalism.