Tariffs: What now for inflation linked bonds?

President Trump’s ‘Liberation Day’ delivered a more severe set of tariffs than what market was expecting. Once the implementation phase is completed, tariffs are set to surge to about 25%, marking the highest tariff level in over a century, up from 2.3% at the end of last year.  We believe that the unequivocal result of this action, is the materialisation of a stagflationary environment in the US that we have been forecasting over the past months.  Indeed, the probability of a US recession has increased, and market participants have incorporated this outlook, as seen in the sharp drop of equity markets and credit spreads widening. US trade-dependent countries such as Canada, Mexico and the Eurozone are at risk. However, Eurozone fiscal stimulus can provide some offset while China’s fiscal outlook is less clearly supportive. All-in, we believe that the growth backdrop remains tilted to the downside supporting government bonds overall.

In terms of monetary policy, little was announced. On Friday, Federal Reserve (Fed) Chairman Powell said tariffs could have persistent impact on inflation and lead to slower growth. We believe that the Fed won’t act preemptively, unless there is a further decline in equity markets resulting in a material tightening of financial conditions. 

Elsewhere, with global recession risks increasing, we expect the European Central Bank (ECB) to keep cutting rates to 1.5% (with April and June back-to-back) and the Bank of England to cut in May, August and November, despite rising inflation pressures. 

And linkers in all this… Do they still make sense?

In the aftermath of the announcement on 3 April, the market reaction translated into a material drop in interest rates and the increase in short term inflation expectations, particularly in the US. Real yields declined in a bull steepening fashion mirroring their nominal counterparts. This felt a pretty logical reaction since the tariff implementation may lift US inflation by as much as 2% next year. Plus, ongoing migration restrictions could keep the labour market tight and therefore services inflation structurally higher. 

On 4 April, however, the surprising oil production increase from OPEC+ triggered a selloff in breakevens (almost -15bp on the day), taking the real yields of maturities below 10 Years higher. In our view, Friday’s disorderly reaction has taken breakevens back to attractive levels as inflation risks remained tilted to the upside.  This is the case in all markets including the Euro Area, where we have been less constructive recently.  With the combination of lower real yields and breakeven correction, we expect inflation linked bonds to outperform nominal bonds as inflation prints above market expectation in the coming months.

Thoughts on real duration: cautiously long 

Given the higher volatility, we decided to take profits on our US long duration positions at the 5 Yr tenor.  While we expected the move in real yields to be lower, our year-end target of 1% was reached and we decided to neutralise the position.  Having said this, the sell off after Chairman Powell’s remarks on 4 April, seem overdone and we are monitoring the levels to add fresh longs in the portfolio.  Elsewhere, we like to hold long real yields as we see an overpricing of fiscal-induced future growth in Europe and the UK. 

Thoughts on breakevens:  spOILed valuations

On Friday, oil prices declined to levels not seen since 2021 as OPEC+ announced a larger output hike in May on top of the demand shock. However, despite being an oil-driven sell off, breakeven forwards sold off and we find breakevens valuations attractive. On another note, we believe that any retaliatory tariffs put in place by the EU in response to US tariff could potentially have an inflationary impact on HICP with likely disruptions to global supply chains also increasing prices in the region.  Coupled with mounting recession risks in the US, we decided to take full profits in our cross market breakeven trade of long US CPI vs HICP at the 10 Year tenor.

The tariff escalation is likely a regime shift, not a noise event, and recession risks are no longer a tail event, but a baseline. In this environment, inflation-linked bonds should offer asymmetric upside. The sharp repricing in breakevens presents a rare entry point, as inflationary pressures are structurally underpriced across major markets. Real yields are approaching levels inconsistent with deteriorating growth and tightening financial conditions, warranting a strategic re-engagement. We believe there is a clear path forward: own what benefits from structural inflation, fade growth optimism, and stay positioned for a world where volatility is the new risk-free rate. Remember, markets are conditioned for mean reversion; they are not prepared for paradigm breaks.