Markets are mispricing tariff uncertainty, say academics

Johns Hopkins economists warn of risk from changes to the ‘rules of the game’

Traders are underpricing the risk posed by uncertain US trade policy, say economists at Johns Hopkins University.

Steve Hanke – a former adviser to President Reagan – and Matt Sekerke say even a scenario where tariffs come to rest close to historical levels would leave a continuing risk that US policy-makers change course or renege on existing agreements.

“From the bond market to the equity market, everybody’s just sleepwalking,” says Hanke. “The mispricing is pretty dramatic.”

Sekerke, senior macro adviser at Hiddenite Capital Partners and fellow at Johns Hopkins, says: “Whatever bedrock we thought we had in the economy is potentially fodder for negotiation again.”

The uncertainty presents a problem for the industry. “Whether you’re on the buy side or the sell side, you’ve got to put stakes in the ground, set up your model, make some assumptions. But in the current environment, whatever correlations you thought you could lean on in the past are not as useful as a reference going forward.”

Just because we haven’t seen it yet – a bank didn’t implode on April 2 – isn’t proof that something isn’t wrong

Matt Sekerke, Hiddenite Capital Partners

Sekerke predicts tariffs and ongoing uncertainty will lead to economic slowdown, especially with a government also looking to cut spending.

“We’re headed into kind of a deflationary, slow malaise,” he says about the US economy. “I’m not expecting big collapses. I see us more grinding to a halt than having catastrophic failures.”

Hanke, a professor of applied economics at Johns Hopkins and former member of Reagan’s Council of Economic Advisers, compares current events to the upheaval in the 1930s when the US government’s role in the economy and society changed drastically.

“The big risk, I call ‘regime uncertainty’,” he says. “That’s not where you have one supply chain that’s somehow disrupted. It’s the whole regime changing – the institutional structure gets changed as well as micro policies. If you’re making a long-term investment, you have to be assured of what the rules of the game are and what your net return from that investment might be,” he says.

Steve Hanke

The S&P 500 dropped 12% in the days after the US president Donald Trump announced so-called retaliatory tariffs on April 2, only to claw back two-thirds of the losses on April 9 when Trump announced a 90-day pause on many of the steeper rates. The index has closed higher than its April 8 low in the weeks since.

Credit markets have shown a similar pattern. Investment-grade and high-yield US corporate bond spreads to Treasuries have narrowed from their widest levels in the days after April 2.

Sekerke reckons tariffs could drive spreads wider on some corporate bonds. “That’s an area where some air could come out of the balloon,” he says. “High-yield spreads haven’t been anywhere near fair for about 15 years because of everybody stretching for yield.”

Credit traders have responded less aggressively to the tariff uncertainty compared with traders in equities. The asset class has long benefited from an investor rush for yield, including from foreign managers seeking higher-yielding assets than their domestic alternatives, and from a supply-demand imbalance that has helped push yields lower.

Related

Credit markets brace for Trump tariffs fallout 

Traders have largely shrugged off the threat of global trade wars, but worries remain about economic weakness

Investors expressed worry about a potential trade war before President Trump took office, making it the third biggest risk according to Risk.net’s annual investment risk survey. But predicting the potential impact of pre-inauguration tariff threats posed a challenge, and the S&P 500 went on to reach an all-time high in February.

Even with recently enacted policies, investors have had a hard time deciphering the impact tariffs might have given the range of possible outcomes and the uncertainty that levies will stay in place for the long term. Punitive US tariff rates and retaliatory measures by US trading partners could drive the global economy into recession – or tariffs could disappear just as suddenly in a temporary pause or trade agreement.

“It’s an enormous stress test that nobody was planning for,” says Sekerke.

The biggest signs of strain in recent weeks appeared in US Treasury markets where funds unwound a popular leveraged trade betting on cash bonds outperforming interest rate swaps and a tepid auction raised alarm bells to which some worried the Trump administration was slow to respond.

Sekerke worries further stresses may emerge. “There haven’t been a lot of very public manifestations of stress in the financial system from this. Just because we haven’t seen it yet – a bank didn’t implode on April 2 – isn’t proof that something isn’t wrong,” he says.

Editing by Rob Mannix