Highlights:
- We expect tariff-driven price increases to surface in Q3–Q4 2025. With Bessent’s increased role in Trump’s policymaking, tariff policies have shifted from being led by hardliners to moderates. We believe that the U.S. effective tariff rate could fall between 10% and 20%. The U.S. inflation could return to a higher level of around 4% YoY.
- Another inflation driver is weak U.S. dollar. A weaker dollar is likely to further increase the price of imported goods. “One Big Beautiful Bill Act” could partially offset negative economic impacts of tariffs but also drive inflation and worsen deficits. The labour market might be cooling soon.
- The US could enter mild stagflation in the second half of 2025, i.e. slowing growth and accelerating inflation. We expect the Fed could cut rates within the year (Q3 to Q4), but due to the inflation resurgence risk, we anticipate no more than two cuts this year.
- We believe long-term bond yields face upward pressure. Investors could consider ultra-short-term U.S. Treasuries (e.g., six-month treasury). Investors could use a rollover strategy, means reinvesting the principal in six-month treasury again upon maturity.
- Investors could consider high-quality short- to medium-term corporate bonds. We prefer investment grade issuers and defensive corporate bonds under tariff wars.
Tariff-induced Price Increases to Surface in Q3 to Q4
In May 2025, US CPI and core CPI rose by 2.4% and 2.8% YoY respectively, appearing subdued and close to the Fed’s 2% target. These figures do not yet reflect effective control over inflation.
As shown in Chart 1, starting from March 2025, ISM Manufacturing Survey’s Prices Paid for Manufactures (input costs) surged to its highest level since June 2022, likely due to supply chain bottlenecks and pre-emptive inventory stockpiling by manufacturers. If these costs are passed on to consumers, it could eventually exert greater inflationary pressure.
Chart 1: US CPI & ISM Manufacturing Survey
Given that trade negotiations under a tariff war typically take months or even years to finalize, and tariffs on intermediate goods require time to translate into final prices, inflationary effects will be delayed. Thus, we expect tariff-driven price increases to surface in Q3–Q4 2025.
U.S. Inflation could Return to Around 4% YoY
With Bessent’s increased role in Trump’s policymaking, we note that White House policies and rhetoric have begun to consider capital market performance. Bessent has commented multiple times after sharp rises in US Treasury yields to stabilize market confidence. Tariff policies have shifted from being led by hardliners (Secretary of Commerce, Lutnick) to moderates (Bessent).
This suggests that the White House, or Bessent, recognizes the importance of Treasury stability for executing Trump’s policies. One of the White House goals is to reduce fiscal deficits, with Treasury yields seen as the Government’s refinancing cost, creating an incentive to suppress yields. This indirectly indicates that the White House is unlikely to jeopardize the U.S. dollar’s or Treasuries’ hegemonic status (as a primary settlement currency, commodity pricing currency and reserve currency).
In fact, Bessent still advocates tariffs as a new revenue source for the U.S. government. Even under Bessent’s leadership, tariff negotiations carry significant uncertainty, as they involve geopolitical bargaining, not just unilateral U.S. policy.
As shown in Chart 2, according to The Budget Lab’s latest analysis, the US effective tariff rate in May was 17.8%, comparable to the Hoover administration in the 1930s, far exceeding the past 80 years’ levels and up 15.4% from 2024 (see Table 1). If the U.S. secures suitable substitutes, the effective tariff rate could decrease by 140 basis points to 16.4%, but the timeline for finding substitutes remains uncertain (ranging from weeks to years).
Balancing fiscal revenue (tariffs cannot be too low to be effective), national interests, and risks of retaliation, we believe the U.S. effective tariff rate could fall between 10% and 20% (see forecast in Chart 3), still higher than the past 80 years. Tariffs are expected to significantly impact inflation and drag on economic performance.
Chart 2: US Effective Tariff Rate
Table 1: Estimated U.S. Effective Tariff Rates
Effective Tariff Rate | Import Share | Average Effective Tariff | |||
Pre-Substitutes | Post- Substitutes | Pre-Substitutes | Post- Substitutes | ||
China | 33.2% | 14% | 6% | +4.5% | +2.0% |
Canada | 17.2% | 13% | 15% | +2.2% | +2.6% |
Mexico | 14.7% | 15% | 17% | +2.3% | +2.5% |
Rest of the World | 11.9% | 58% | 62% | +6.4% | +6.8% |
Total Change (vs End of 2024) | 100% | 100% | +15.4% | +14.0% | |
Average Effective Tariff Rate | 17.8% | 16.4% | |||
Source: The Budget Lab analysis, GTAP v7, iFAST Compilations Data as at 12 May 2025 | |||||
The Budget Lab estimates that these new tariffs will drive short-term inflation up by 1.7%, implying U.S. inflation could return to around 4% YoY, with inflation likely to accelerate again.
“One Big Beautiful Bill Act” could partially offset negative economic impacts of tariffs but also Drive Inflation and Worsen Deficits
The Trump administration favors a weaker dollar to enhance U.S. export competitiveness and relieve trade deficits. Additionally, market expectations of worsening U.S. fiscal deficits, with no short- to medium-term solutions, have reduced confidence in the dollar among some market participants.
These factors have led to a weaker dollar (see Chart 3), with the U.S. Dollar Index falling 8% year-to-date to 99.8. A persistently weaker dollar is likely to further increase the price of imported goods (in USD terms), typically with a lag of about six months to a year. Beyond tariffs, a weak dollar is another key driver of inflation, or resulting in the self-looping between a weak dollar and an increasing inflation in a negative scenario.
Chart 3: U.S. Dollar Index and Imported Price Index
Recently, the “One Big Beautiful Bill Act” passed the House. As shown in Chart 4, the Senate version of the bill is projected to generate a cumulative budget deficit of up to $6 trillion over the next decade, exceeding the sum of previous plans. This aggressive fiscal policy could partially offset the negative economic impacts of tariffs but also drive inflation.
Chart 4: “One Big Beautiful Bill Act” Budget Deficit
This makes it harder for Trump to achieve his deficit reduction goals. With the bill’s passage, U.S. deficits are likely to worsen, keeping government debt levels elevated.
The Labour Market might be Cooling Soon
The non-farm payrolls in May increased 139,000 jobs (see Chart 5), exceeding market expectations, with the unemployment rate steady at 4.2%, close to full employment. While releasing May data, officials revised down March and April numbers, with a combined reduction of 95,000 jobs, suggesting a risk of gradual cooling in the labour market.
Chart 5: US Non-farm Payrolls and Unemployment Rate
However, high tariff policies take time to affect corporate hiring, and the labour market may cool in the future. The current strong employment data is largely driven by part-time workers. Since 2024, full-time employment growth has slowed to a range of -2% to 2% YoY (see Chart 6), showing signs of cooling. Part-time jobs are less stable, and if firms anticipate slower economic growth, they could cut part-time workers first, potentially leading to a rapid labour market slowdown that may not align with current headline data.
Chart 6: US Full-time Employment and YoY
The US could Enter Mild Stagflation in 2H25; Anticipate No More than Two Cuts this year
Overall, the delayed tariff impacts, non-moderate tariff negotiation outcomes, a weaker dollar, aggressive fiscal policies and deglobalization trends are likely to reignite inflation while economic growth slows due to tariffs. We believe the U.S. could enter mild stagflation (slowing growth, accelerating inflation) in the second half of this year.
If tariff negotiations worsen significantly, the U.S. could face more severe stagflation (recession with high inflation).
The Fed is currently cautious and has not responded to Trump’s calls for rate cuts, as their goals differ:
- The Trump administration adopts “Make America Great Again” (MAGA) as its core theme, with policies like higher tariffs, tax cuts (corporate and personal) and spending reductions to ease deficits.
- The Fed aims to balance inflation and employment. With tariff impacts not fully realized, the Fed is hesitant to cut rates, as this could reignite or exacerbate inflation.
The May Fed meeting minutes show that nearly all 19 participants expect inflation to persist longer than anticipated but are also concerned about rising unemployment risks. However, their concern about inflation currently outweighs unemployment fears, leading to a decision to keep rates unchanged in May.
If recession risks rise and the labour market weakens, the Fed may have an incentive to cut rates. We expect the Fed could cut rates within the year (Q3 to Q4), but due to the inflation resurgence risk, we anticipate no more than two cuts this year (see Chart 7).
Chart 7: US Benchmark Rate (Lower Bound) and FSMOne Prediction
Long-term Bond Yields face Upward Pressure; Could consider Ultra-short-term U.S. Treasuries
We believe long-term bond yields face upward pressure, as they have not fully priced in the risks of inflation resurgence or stagflation, or adequate term premiums to compensate for additional duration risks.
We expect zero to two rate cuts this year, less than the market expectation of two to three rate cuts. This slower pace of the rate cut is not fully reflected in long-term bonds.
As events unfold, 10-year Treasury yields could exceed 5% again, and the yield curve could steepen further.
For stable income, investors could consider ultra-short-term U.S. Treasuries (e.g., six-month treasury) with a current yield to maturity of around 4.3%. Investors could use a rollover strategy, means reinvesting the principal in six-month treasury again upon maturity. This is a low-duration-risk, flexible investment approach.
We believe the entry point for long-term bonds is when they offer sufficient term premiums (10-year minus 2-year yields > 100 basis points). Based on current 2-year yields, 10-year yields should be 5% or higher to compensate for higher duration risks.
Chart 8: Yield Curve
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Could Consider High-quality Short- to Medium-Term Corporate Bonds; Preferences for Investment-Grade Issuers and Defensive Corporate Bonds Under Tariff Wars
For investors looking for longer duration or seeking higher-yield opportunities, they could consider the high-quality short- to medium-term corporate bonds (primarily 2 to 5 years). Unlike US Treasuries, most corporate bond yield curves are upward-sloping (longer-term bonds offer higher yields than shorter-term bonds of the same issuer and seniority), which makes slightly longer-term corporate bonds generally more attractive in terms of yield or investment value.
We prefer two types of issuers: (1) investment grade issuers and (2) defensive corporate bonds under tariff wars. They are better positioned to withstand macroeconomic uncertainties:
(1) Investment Grade Issuers
- Investment-grade bonds carry lower credit risk and are more resilient to stagflation risks. Amid expectations of slowing economic growth, their credit performance is likely to remain stable, with default risks remaining well-contained.
- Currently, investment-grade issuers offer yield to maturity averaging around 5%. For 2- to 5-year investment-grade bonds, yield to maturity of 4.8% or higher are widely available, making them suitable for investors seeking yield pick-up on top of Treasuries. They could have a certain investment value.
(2) Defensive Corporate Bonds Under Tariff Wars
- These are typically non-U.S. issuers with significant local operations and minimal reliance on global supply chains, or companies in labor- or knowledge-intensive service sectors, which are less directly impacted by recent tariff wars.
- Their operations, revenues, and profit margins are less vulnerable to disruptions from trade system restructuring or shifts in the global economic order, supporting more stable credit profiles.
- Bonds from these defensive companies face lower risks of credit spread widening and currently offer attractive relative or absolute yields.
For bond selection guidance, investors can refer to these articles:
- Investment Opportunities in the Bond Market Amid a Tariff War
- Idea of the Week: Defensive Corporate Bonds Under Tariff Wars—Corporate Bond Yields Up to 8.6%!
Regarding high-yield issuers, while their overall credit conditions have improved, investors have to be cautious for cyclical industries and those more exposed to trade or geopolitical risks (see Chart 9). High-yield issuers in these sectors could experience greater credit changes, so investors should be selective in the high yield space. Investors can refer to our Idea of the Week articles for exploring the investment opportunities.
Chart 9: Industry Exposure to Tariff Impacts
Source: Apollo Global Management, iFAST Compilations
Declaration: For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.
