The Big Idea

Pinball wizard

Steven Abrahams | April 11, 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.

After Wednesday brought us the valuable new information that market reaction to tariffs matters to the US, Thursday showed that the foundational problem of uncertainty in markets remained. The continuing lack of clarity on US tariff process and goals leaves investors playing a pinball game of risk. Investors in that setting have every incentive to price assets toward the worst case and just wait. The direction of markets over the next 90 days will almost certainly depend as much on the clarity of tariff negotiations as it will on results.

The download from Wednesday

Wednesday showed that some combination of lower equities, lower commodities, wider spreads, higher rates, higher volatility and the like were not the price the administration expected to pay for trade reform. The extremes on these markets should signal a floor for where the US may shift direction if it reengages after the 90-day tariff pause. That gives markets the first indication of a knowable downside.

The decision to deescalate and pause tariffs with all countries and lower all tariff rates to 10%—except for immediate 125% tariffs on China—also suggests the administration’s message from its 7-day shock-and-awe tariff war may be more important than its results. The US can now claim it forced the world to reconsider tariff and non-tariff barriers to trade. Trading partners now know US willingness to escalate aggressively, but also the US reaction function to markets. Different partners will put different weights on those. But all partners have incentives to find ways to accommodate the US at least optically. The US administration should be able to emphasize the message about tariffs long before the message gets measured against actual results, especially over the period from today until November 3, 2026. If the message is the prize from this initial battle, the US may not reengage to force immediate measurable results.

Some steep tariffs stay in place for now. Treasury Secretary Bessent said separate 25% tariffs on autos, auto parts, steel and aluminum will remain while other “sectoral” tariffs on lumber, pharmaceuticals and possibly other goods are in the pipeline. Tariffs of 25% on imports from Mexico and Canada that do not meet terms of the 2020 US-Mexico-Canada Agreement will also stay.

Persistent uncertainty

On Thursday, uncertainty about trade policy came storming back. Uncertainty can break markets. George Akerlof once described it as a market for lemons. In markets where information about the quality of an asset—or the performance of an investment, in this case—is opaque, buyers assume that only assets below the average come to market. That sets off a race to the bottom in quality where eventually only desperate sellers are offering the worst assets.

For companies exposed to tariffs, the rapid changing US stance on tariffs and the changing goals—from raising federal revenue to onshoring of production to elimination of trade imbalances—has made determining potential investment risk and reward extraordinarily opaque. That set of companies includes ones that get revenue or source inputs from outside the US. In the second quarter of 2024, according to S&P, the S&P 500 sourced nearly 29% of revenues from outside the US. It is consequently hard to avoid tariff exposure in the equity, leveraged loans, high yield and investment grade debt offered by those companies.

Baker, Bloom and Davis publish a daily economic policy uncertainty index, scored from the text of news articles from 10 major media outlets. On Thursday, that stood at 467% of its average over the last five years (Exhibit 1). The VIX index, measuring expected price volatility in the S&P 500, stood on Thursday at 374% of its 5-year average. And the MOVE index, measuring expected rate volatility across the US Treasury curve, stood at 233% of its 5-year average. The VIX had strikingly doubled since the April 2 Liberation Day.

Exhibit 1: Soaring uncertainty in media coverage, equities and rates markets

Note: Uncertainty index from Baker, Bloom and Davis.
Source: Bloomberg, Santander US Capital Markets.

The source of uncertainty

The uncertainty around tariffs reflects the extraordinary concentration of power in the White House and the often conflicting and unpredictable signals about process and goals. That concentration might seem surprising since constitutional authority over tariffs under Article 1, Section 8, rests with Congress. Congress did set all tariffs in the US until the Smoot-Hawley Act of 1930 raised tariffs, triggered a global trade war and contributed to a drop in US exports three years later by at least 60%. After that, Congress started ceding authority to the executive. The Reciprocal Trade Agreements Act of 1934 allowed the president to negotiate bilateral trade agreements and adjust tariff rates without action by Congress. The Trade Expansion Act of 1962 let the president negotiate multilateral agreements and impose tariffs or restrict imports that threatened national security. The Trade Act of 1974 further expanded executive power over trade and tariffs. In the long run, the US would do well to bring some of that power back to Congress where presumably it could ensure a more open process.

Promise or peril over the next 90 days

This 90-day pause will be genuinely valuable if it leads to more clarity on US process and goals. If the US administration consults more publicly with Congress and the private sector, that should help. If the US lays out specific issues with specific countries or describes a broad multi-lateral goal, that should help. If the US consults more publicly with trading partners, that should help. Even if the administration provides this kind of clarity, simultaneously negotiating bilateral agreements with dozens of countries or a large multilateral agreement is a herculean task with plenty of opportunity for conflicting messages. The administration would need to manage the messaging closely.

On the other hand, if the administration offers a broad promise to deliver a final package of negotiated tariffs in 90 days with no definition of success or no regular effort to provide a clear and regular updates on progress, the market should price toward a worst case and wait.

We’ve seen Liberation Day I. Without clarity, some may invest despite the possibility of Liberation Day II, but many will not. With clarity, many more investors should feel comfortable pricing a smaller risk premium and coming back into the market.

The new picture from Wednesday of the US tariff reaction function should create some marginal room for more risk. If we get more clarity over the next 90 days, adding to that risk should make sense, too.

* * *

The view in rates

The market this week trimmed its expectations for Fed cuts by one and sees funds at 3.54% to end the year, roughly one more cut than the Fed’s March dots. The market has the first cut priced for June, a second cut in September and a final cut in December. That will likely require the Fed to look through the inflationary impact of the administration’s remaining tariffs, assuming that they hold, and focus on the risks to growth.

Other key market levels:

Fed RRP balances closed at $99 billion as of Friday, down $86 billion in the last week.
Setting on 3-month term SOFR closed Friday at 424 bp, down 4 bp on the week.
Further out the curve, the 2-year note traded Friday at 3.96%, up 31 bp in the last week. The 10-year note traded at 4.48%, up 49 bp in the last week.
The Treasury yield curve traded Friday with 2s10s at 52 bp, steeper by 18 bp in the last week. The 5s30s traded Friday at 71 bp, steeper by 1 bp over the same period
Breakeven 10-year inflation traded Friday at 223 bp, up 4 bp in the last week. The 10-year real rate finished the week at 226 bp, up 46 bp in the last week.

The view in spreads

Bearish on credit spreads with US trade policy in flux. The Bloomberg US investment grade corporate bond index OAS traded on Friday at 1114 bp, wider by 12 bp in the last week. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 156 bp, wider by 6 bp in the last week. Par 30-year MBS TOAS closed Friday at 41 bp, wider by 4 bp in the last week.

The view in credit

Tariffs should weaken most credits assuming slower growth, and hit specific credits hard based on exposure to cross-border trade flows. Excess returns from the first week of tariff war point to the specific sectors more or less exposed to tariff. We have been watching cracks in credit quality at the weaker end of the credit distribution for months. Fundamentals for the average of the distribution 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. However, serious delinquencies in FHA mortgages and in credit cards held by consumers with the lowest credit scores have been accelerating. Consumers in the lowest tier of income look vulnerable. 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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