Summary

Trade talks between senior U.S. and Chinese officials last week in Switzerland resulted in a significant rollback of U.S. tariffs on imports from China—from 145% to 30%—triggering a sharp rally in risk assets. The S&P 500 index has rebounded, erasing its losses since the April 2 “Liberation Day” tariff announcements in Washington and global equities (the MSCI ACWI) are up year-to-date. U.S. investment-grade and high yield corporate bond spreads have also tightened.

The Trump administration’s May 12 announcement, that additional U.S. tariffs on Chinese imports would be temporarily reduced by 115 percentage points (ppt), to 30%, notably exceeded market participants’ expectations of a decrease to about 50%. By our calculations, the overall U.S. trade-weighted tariff rate is now around 13%, substantially below the estimated 23% in place over the past month.

While the outlook for U.S. trade policy remains uncertain, we believe this outcome, and other recent developments, suggest a reduced risk of downside tail scenarios involving elevated tariff rates and serious supply chain disruptions. Assuming the U.S. maintains additional tariffs on China at 30% and that tariffs on the pharmaceutical and semiconductor sectors take effect, we have updated our baseline assumption and expect the effective U.S. tariff rate to settle around 16%—slightly below our previous assumption of 18%.

Synchronized growth outlooks; differentiated inflation prospects 

Given our expectation of a smaller tariff impact on the U.S. economy, we have raised our 2025 Q4/Q4 GDP growth forecast by 0.4 ppt, to 0.9%, and reduced our 12-month recession odds to around 30%, from 45%. The de-escalation of U.S.-China trade tensions also presents a more favorable scenario for the global economy. Stronger growth in the U.S. and China will likely have positive spillover effects on the rest of the world.

But even as major economies’ growth outlooks are becoming more synchronized, we continue to see differentiated inflationary outcomes due to the trade war. These have varying implications for central banks. As we assess two-way risks to growth and inflation, we see relative value opportunities in bond markets, where we are neutral on the U.S., underweight Japan and find potential for overweights in the euro area. 

The U.S.

For the U.S., the trade war almost certainly will pose an adverse supply shock, dampening growth while pushing up inflation. This scenario would present a challenging situation for the Federal Reserve (Fed), putting its dual mandates—price stability and maximum employment—in conflict. Despite diminished cost-push inflationary pressures from recently lowered tariffs, we still expect core CPI inflation to be around 3.8% year-over-year (y/y) by the end of 2025, notably above the Fed’s inflation target of 2%.

Recent Fed communications indicate a careful approach to the U.S. inflation outlook. While the Fed recognizes the transitory nature of tariff-induced inflation, it is concerned that persistent above-target inflation could de-anchor inflation expectations to the upside. With the improved growth outlook and softer inflationary pressure, we expect the Fed to remain in a wait-and-see mode.

We have postponed when we expect the Fed to cut rates, to September from July, with one more cut likely in December. We believe risks are tilted toward fewer cuts this year, as we think the Fed will wait for labor market weakness before cutting rates, especially if household inflation expectations continue to rise, as they have in recent surveys.

In contrast, the trade war represents a negative demand shock to the rest of the world, leading to weaker growth and inflation, offering more flexibility for other central banks to respond depending on domestic conditions. 

The euro area

In the euro area, underlying inflationary dynamics appear to remain benign. An upside surprise in April's core inflation print was due largely to holiday-related services and reflect the timing of Easter. Inflation will likely decelerate in May. We expect that a subdued growth outlook, along with a strong euro and low inflationary pressure from China, should keep the euro area’s disinflationary process on track.

While the de-escalation of U.S.-China trade tensions has weakened the case for rapid monetary accommodation by the European Central Bank (ECB), we still see room for the ECB to cut below our current assumption of a terminal rate at 1.75%, given the region’s soft growth and muted inflation.

Japan

Recent data showed signs of more persistent inflationary pressure in Japan, particularly in food prices. However, we expect inflation to soften in the second half of 2025 as growth decelerates, y/y base effects for goods prices diminish and new gasoline and utility subsidies are introduced.

The Bank of Japan (BoJ) has also turned more cautious in its inflation outlook. In its latest Outlook Report, the central bank postponed by a year, to fiscal year 2027, the timing for achieving its inflation target of 2%. While the U.S.-China trade deal has lifted market participants’ expectations for a BoJ rate hike this year, we believe U.S.-Japan trade talks are still clouded by elevated uncertainty.

We maintain our base case that the next BoJ hike will occur in January 2026. However, if the U.S. makes consequential progress in its negotiations with Japan and other trading partners by this summer, a BoJ hike in Q4 is possible.

Investment implications

We generally favor duration outside the U.S., where disinflation, growth and fiscal outlooks are more predictable. This preference is influenced by valuations, particularly in higher-yielding regions where central bank actions are less anticipated, and by carry opportunities, notably in Italy and Australia. We anticipate that some central banks will need to lower policy rates to the lower end or below neutral R* estimates. Others like the U.S. and Japan may maintain rates at or above the upper range due to persistent economic strength, whether driven by fiscal policies or residual strength from recent years (Exhibit 1). 

The dynamic presents relative opportunities in regional bond markets. In the U.S., we maintain a neutral stance on bonds from a relative value perspective. The uncertainty surrounding growth and inflation, coupled with tariffs’ likely stagflationary impact, leaves the Fed’s response less predictable. The Fed’s March 2025 Summary of Economic Projections and more recent Federal Open Market Committee speeches, suggest a slight inclination toward prioritizing inflation concerns over growth, although this remains a close call.

We see opportunities for overweights in Europe, favoring in particular Italian bonds over German Bunds due to their high carry, low spread risk and high relative correlation to Bunds. Italy presents low fiscal risk with limited room for deficit expansion, whereas Germany is likely to see its debt-to-GDP ratio rise from 60% to a potential ceiling of 90% over the coming years. Although the economic impact is uncertain, such a fiscal impulse could add a few tenths of a percentage point to annual euro area GDP, and around 50 basis points to Germany's annual growth from 2026 onwards.

Global tariffs and trade disruptions are likely to impact euro area growth and inflation negatively in the near term. The European Union’s (EU's) deliberate decision-making contrasts with the U.S. government's aggressive tariff rhetoric and negotiation deadlines. While both sides aim for a deal, the EU's higher expectations and focus on quality over speed present challenges. Sticking points include tariffs on pharmaceuticals, digital services tax, and potential EU retaliatory tariffs, complicating negotiations compared to smaller trade partners.

The trade disruptions affect the euro area through supply and demand dynamics. U.S. tariffs on EU exports make EU goods less competitive, reducing export demand and shifting the demand curve leftward. Meanwhile, trade diversion occurs as countries such as China redirect exports to Europe, increasing supply and shifting the supply curve rightward. This increased supply puts downward pressure on prices, contributing to disinflation. Additionally, a stronger euro makes imports cheaper, further lowering inflationary pressures.

The net effect is reduced demand and increased supply, leading to disinflation in Europe, even as tariffs raise prices in the U.S. This framework, supported by studies from the European Parliament and Centre for European Policy Studies (CEPS), suggests that while ECB policy may be fairly priced in the futures market, the central bank will likely maintain near-accommodative interest rates longer than investors currently expect.

In the UK, we find Gilt valuations appealing with high real yields and a limited amount of interest rate cuts priced into the futures market for the Bank of England (BoE). We anticipate that BoE policymakers will need to cut rates further and maintain accommodative rates longer than the market expects, given government fiscal constraints as well as a slowing labor market, despite the BoE’s focus on inflation expectations.

Australia also offers favorable sovereign bond valuations and a highly positive carry market with high real yields. Inflation data is becoming more controlled as the economy cools. While the labor market remains strong, it is gradually loosening.

Our fixed income portfolio underweights include Japan, where we take a cautious outlook. Despite the BoJ's less optimistic economic and inflation outlook, we believe inflation trends remain strong. April's tariff announcements nearly eliminated expectations for BoJ hikes, assuming no rate hikes during a global downturn. Although tariffs have de-escalated, the market expects the BoJ to proceed slowly, reaching a lower terminal rate, with a 1% neutral rate unlikely within two years. That expectation seems reasonable, and it was broadly confirmed during the BoJ meeting in May.

While real rates remain negative, the policy rate is at a 30-year high, and the BoJ is known for its cautious approach. We continue to use Japan as a funding source but remain guarded about position sizing.

We also favor Canada as a funding market. Despite the economy’s relatively weak consumption, labor market and inflation, the central bank’s valuation appears well-priced. On the fiscal side, recently elected Prime Minister Mark Carney plans aggressive new spending on housing and public services and tax cuts, aiming to protect the vulnerable economy from more restrictive U.S. trade policies. This should keep yields range bound on a relative basis to other markets where central banks have been less proactive.

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