Tariff uncertainty unlikely to derail US markets, says Capital Economics

Capital Economics maintains a bullish outlook for US equities and the dollar, expecting them to rally despite ongoing uncertainty surrounding US tariff policy, with a new deadline for 'Liberation Day' tariffs set for early August. While initial market concerns about policy uncertainty have largely diminished, the firm emphasizes that this uncertainty will significantly influence the Federal Reserve, as FOMC members are likely to delay rate cuts until the inflationary effects of tariffs become clearer. Capital Economics doubts the Fed will cut rates this year, a stance that could negatively impact Treasury bonds but eventually bolster the dollar.

Analysis

US equity markets are demonstrating notable resilience, trading near all-time highs despite persistent uncertainty surrounding US tariff policy. According to Capital Economics, this investor confidence is expected to persist, supporting a rally in both US equities and the dollar through the remainder of the year. Market concerns about trade policy uncertainty, which appeared to trigger sell-offs in April, have largely dissipated, evidenced by the muted reaction in equity futures and the dollar to the recent extension of the tariff pause. While the Treasury bond market has recovered since April, this is attributed to a complex dynamic where higher term premia, potentially reflecting policy uncertainty or deficit concerns, are being offset by increased expectations for rate cuts. The primary impact of the tariff situation, however, is its influence on the Federal Reserve. Many FOMC members seem reluctant to lower interest rates until the inflationary effects of the final tariff structure, potentially clarified after the early August 'Liberation Day' deadline, become clear. Consequently, Capital Economics forecasts that the Fed will not cut rates this year, a stance that presents a headwind for Treasury bonds but could ultimately provide a catalyst for dollar appreciation.

Key Decisions for Investors

• Given the market's resilience and the bullish outlook on equities, investors might consider maintaining or adding to US equity positions, while acknowledging that sentiment is heavily tied to the Federal Reserve's policy path.
• Investors should exercise caution with long-duration Treasury bonds, as a more hawkish-than-expected Federal Reserve that refrains from cutting rates this year could lead to higher yields and price declines.
• Monitor the US dollar for a potential reversal and strengthening trend, as a delay in Fed rate cuts could create a positive divergence against other central banks and outweigh current weakness.
• Closely watch for any clarity on the 'Liberation Day' tariffs in early August and subsequent Federal Reserve communications, as these will likely be the key catalysts determining the next major move in rates and currency markets.