The Big Idea

The tariff trade in US rates and credit

Steven Abrahams | February 7, 2025

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

The market has priced the tariff news that broke last weekend, with the US yield curve flatter in the immediate aftermath and credit spreads in vulnerable sectors more volatile. If the tariff threats are real, the moves all make sense. If they are sound and fury, the effects should start to unwind.

The trade in rates

The market has expected tariffs to affect both prices and growth—rising prices in the short run, slower growth in the long run. With the rattling of tariff swords starting February 1, the market has translated those expectations into a flattening of the yield curve. In pictures:

The 2s10s curve has flattened by 9 bp, the 5s10s by 5 bp:

Source: Bloomberg, Santander US Capital Markets

Inflation expected in the short run has moved higher and in the long run lower: implied 2-year inflation rose by 7 bp in the first sessions of the last week, 5-year inflation remained unchanged, 10-year inflation fell 2 bp and 5-year forward 5-year inflation remained unchanged:

Source: Bloomberg, Santander US Capital Markets

Real rates, the clearing price for the supply and demand for money, dropped around 10 bp in 5-, 10- and 30-year maturities in the sessions after the news broke arguably signaling less expected growth and less demand for money:

Source: Bloomberg, Santander US Capital Markets

The 1-month delay in tariffs on Mexico and Canada has put off the moment of reckoning for now and turned up the volume on the debate about whether the tariffs are real policy or just negotiating tactics. So far, the administration has only announced general goals for the tariffs—stop the flow of fentanyl and immigrants across US borders—without a clear definition of success. That grey area may allow the administration to declare victory at any time without implementation. If they are just tactics with no intent to implement, then trade counterparties and the market should slowly stop responding. The headlines become part of the usual background noise.

The trade in credit

The impact of tariffs on credit depends on what the US imports from subject countries since the importer pays the tariff on the goods. The importer can then choose to absorb the cost or try to pass it on to the consumer. If the importer can pass along the cost without any loss of sales from higher prices, then the tariff should be credit neutral. But if the importer absorbs the cost or loses sales, then it is credit negative.

For importers of goods from Mexico, the biggest of the three trade counterparties at least for the last broadly available full year of 2023 at the equivalent of 1.75% of GDP, the biggest impact of tariffs would fall on importers of vehicles, electrical and electronic equipment and machinery:

Note: 2023 figures. Source: Trading Economics, Santander US Capital Markets

For importers of goods from China, the second biggest of the three trade counterparties at the equivalent of 1.64% of GDP, the biggest impact of tariffs would fall on importers of electrical and electronic equipment, machinery and toys, games and sports equipment:

Note: 2023 figures. Source: Trading Economics, Santander US Capital Markets

For importers of goods from Canada, the third biggest of the three trade counterparties at the equivalent of 1.57% of GDP, the biggest impact of tariffs would fall on importers of oil and gas, vehicles and machinery:

Note 2023 figures. Source: Trading Economics, Santander US Capital Markets

Spreads on the debt of US automakers especially have swung around on the tariff news. General Motors imports 25% to 30% of its vehicles from Mexico and Canada, Ford imports 20% to 25%. Spreads on importers of machinery from Mexico, China and Canada have also swung around on the news. As is the case in rates, if these tariffs are more show than sword, the volatility in these spreads should dampen over time.

Negotiation, not policy seems to be winning

So far, the options markets are not showing a lot of concern about immediate movements in aggregate rates or equity, the latter of which would matter most for credit spreads. The MOVE index, built on 3-month options on a range of rate tenors, has moved up a bit around the tariff news but not significantly based on the usual volatility of that measure. The VIX, reflecting equity options, has declined slight, again within the range of normal volatility for that measure. So far, the case that the tariff threats are more negotiation than policy seems to be winning.

Source: Bloomberg, Santander US Capital Markets

It seems a little early to completely write off the possibility of US tariffs and a tariff war, but markets for now are not reflecting much fear. If the news continues to sound mainly like sound and fury without a lot of substance, then investors should be able to generate a little alpha by fading the flattening curve and the widening spreads.

* * *

The view in rates

A healthy January jobs report, including wage inflation and lower unemployment, along with separate data showing rising consumer expectations for inflation have pushed up market expectations for fed funds. Fed funds futures for the end of 2025 have moved from 2 bp over the Fed dot a week ago to 8 bp over as of the Friday close. Beyond 2025, the market continues to fade the dot path, with the market pricing funds 41 bp above the dots at the end of 2026 and 94 bp above the dots at the end of 2027. The futures market that far out is admittedly less liquid, but still a signal of skepticism about the Fed’s ability to eventually cut. The market clearly does not believe inflation is dead. Breakeven 2-year inflation rose 42 bp in January and is up 10 bp in February.

With longer rates, the appetite of foreign official portfolios and rising real rates seem to be playing leading roles. Foreign official holdings of Treasury debt in custody at the New York Fed fell through mid-January, in rough parallel with rising rates, and have since rebounded, in rough parallel with falling rates. Real 10-year rates similarly rose into mid-January and have since dropped back, again in line with the changes in nominal rates.

With discussions of tariffs, changes in immigration policy and an active battle underway in Congress over federal spending, the range of potential paths next year for the Fed has expanded. Rate volatility still does not look fully priced into options markets, especially for longer tenors.

Other key market levels:

Fed RRP balances rose to $95 billion as of Friday, up $12 billion in the last week. With RRP at 4.25%, Treasury repo at 4.38% and MBS repo at 4.42%, cash has much better alternatives than RRP. Balances should continue trending down.
Setting on 3-month term SOFR closed Friday at 430 bp, up 1 bp on the week.
Further out the curve, the 2-year note traded Friday at 4.29%, up 9 bp in the last week. The 10-year note traded at 4.49%, down 5 bp in the last week.
The Treasury yield curve traded Friday with 2s10s at 34 bp, flatter by 1 bp in the last week. The 5s30s traded Friday at 46 bp, steeper by 4 bp over the same period
Breakeven 10-year inflation traded Friday at 243 bp, unchanged in the last 1week. The 10-year real rate finished the week at 207 bp, down 4 bp in the last week.

The view in spreads

Anecdotally, the demand for credit has been fierce. Spreads in many corners of the corporate and structured credit markets stand near, at or below the tightest levels in a decade or more. This is despite US policy uncertainty.

The Bloomberg US investment grade corporate bond index OAS traded on Friday at 82 bp, wider by 2 bp in the last week. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 134 bp, tighter by 4 bp in the last week. Par 30-year MBS TOAS closed Friday at 35 bp, tighter by 3 bp in the last week.

The view in credit

Fundamentals for consumer and most corporate credit continue to look stable. Most investment grade corporate and most consumer balance sheets have fixed-rate funding so falling rates have limited immediate effect. Consumer debt service coverage is roughly at 2019 levels. The rate of serious delinquency in residential mortgages and of loans in foreclosure have barely changed over the last year. The balance sheets of smaller companies show signs of rising leverage and lower operating margins. Leveraged loans also are showing signs of stress, with the combination of payment defaults and liability management exercises, or LMEs, often pursued instead of bankruptcy, back to 2020 post-Covid peaks. If the Fed only eases slowly this year, fewer leveraged companies will be able to outrun interest rates, and signs of stress should increase. LMEs are very opaque transactions, so a material increase could make important parts of the leveraged loan market hard to evaluate.

Steven Abrahams
steven.abrahams@santander.us
1 (646) 776-7864

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