What happened to the US economy? - Tariffs, inflation, bond market, retail investors...

Key Points:

  • Economic and Market Conditions
  • Inflation caused by federal policies and tariffs
  • The impact of tariffs on consumers
  • Deficit-driven bond yield pressure
  • The impact of the Japanese bond market on the US market
  • Market Expectations and Investment Environment
  • The dominance of retail investors in the stock market
  • Investment Advice

Economic and Market Situation

The U.S. economy typically grows, with historical data showing that the U.S. economy has been in expansion about 90% of the time since World War II, with an average annual growth rate of about 2.5%-3%. However, about 10% of years enter a recession due to external shocks (such as financial crises, pandemics, or policy changes), resulting in reduced economic activity and lower consumption. Currently, the market is focused on whether the newly announced tariffs of the Trump administration, such as the 50% tariff on the European Union, which will be suspended until July 9, 2025, will lead to economic contraction. The analysis suggests that the probability of a recession is about 20%, lower than the previous expectation of 50%, but tariffs could push prices higher and trigger inflationary pressures. The impact of inflation on low-income groups is particularly significant, with data from the National Retail Association showing that 50% of U.S. retail sales in 2024 will be contributed by the top 10% of income earners, indicating that wealth concentration is at an all-time high, and low-income groups are more sensitive to price increases.

Inflation Caused by Federal Policies and Tariffs

The market expects the Fed to cut rates 2-3 times in 2025, but the Fed is likely to keep the current federal funds rate unchanged at 4.25% as tariffs could lead to higher inflation. In the first and second quarters of 2022, U.S. GDP shrank by 1.6% and 0.6% respectively (revised slightly positive), but the Fed still raised interest rates by 75 basis points per time as inflation climbed from 3% to 9%, indicating that it is prioritizing inflation control. Currently, Fed Funds futures show that the probability of a rate hike is less than 10% in June 2025, 25% in July, below 50% in September, and only about 55% on October 29. Tariffs could cause a one-time price shock, with the data suggesting significant price increases for products originating in China from May 1, 2025, with the headline consumer price index (CPI) rising 0.7% in 25 days, from 1.3% to 2.1%. If companies continue to pass on costs or use tariffs as a justification for price increases, it could lead to "unanchored inflation," i.e., price increases across the board, forcing the Fed to keep interest rates high.

The Impact of Tariffs on Consumers

Duties are paid by importers, and some of the costs are passed on to domestic businesses and consumers through the supply chain. Corporate profit margins are currently at historically high levels (S&P 500 companies average about 12% in 2024) and are able to absorb some of the cost of tariffs, but tend to pass them on to consumers. Truflation and PriceStats data show that from May 1, 2025, the price of imported goods has risen significantly, and the CPI has risen by 0.7% in less than a month. Tariff policies are designed to stimulate domestic production and encourage consumers to buy domestic products that are not affected by tariffs, potentially changing consumption behavior. For example, Trump's policy of exempting tariffs on U.S.-made products could push consumers to turn to domestic goods and reduce price pressures. However, in the short term, consumers may still face higher prices, especially in low-income groups, as the proportion of imported goods in their consumer goods basket is higher (around 30%-40%).

Deficit-driven Bond Yield Pressure

The U.S. federal government budget for fiscal year 2024 is about $7 trillion, tax revenues are about $5 trillion, and the deficit is $2 trillion, or about 7% of GDP. The deficit is expected to rise to $2.5 trillion in the next few years, or about 8%-9% of GDP. High deficits increase the demand for funds in the bond market, driving yields higher. In May 2025, the yield on the 10-year Treasury note had topped 5%, reflecting rising inflation expectations (the market expects CPI to be around 3% in 2025) and risk premiums (term premiums). The bond market needs to absorb a large amount of government debt, and the financing needs are expected to reach $2.5 trillion per year in 2026-2027. To attract funds, yields could climb further to 5.5%-6%, above the historical average (about 6% on average 10-year Treasury bonds from 1960 to 2020).

The Impact of the Japanese Bond Market on the U.S. Market

The fluctuations in the Japanese bond market (JGB) pose a significant potential impact on the U.S. market, as Japan is the largest foreign holder of U.S. Treasury bonds, holding approximately $1.13 trillion (data as of the end of 2023). In May 2025, the yields on Japan's ultra-long-term government bonds (20-year, 30-year, and 40-year maturities) hit record highs of 2.555%, 3.14%, and 3.6%, respectively, due to weak demand at the 20-year bond auction (the bid-to-cover ratio was the lowest since 2012), reflecting investor concerns about Japan's fiscal sustainability (Japan's debt-to-GDP ratio reached 260%, far exceeding the U.S. ratio of 120%). The Bank of Japan (BOJ) is gradually exiting its bond purchase program (reducing to 3 trillion yen per month starting in 2024), exacerbating the decline in market liquidity and leading to a surge in yields.

Japanese investors (especially life insurance companies and pension funds managing assets over $2.6 trillion) have begun to reduce their investments in U.S. Treasury bonds due to rising domestic yields and increased hedging costs caused by yen fluctuations (the volatility of the yen rose to 10% in the first quarter of 2025). In March 2025, they net sold foreign bonds worth 902.7 billion yen (about $6.1 billion). If Japanese investors continue to sell U.S. Treasuries and instead purchase high-yield domestic JGBs, it could exacerbate liquidity pressures in the $28.6 trillion U.S. Treasury market and push up U.S. Treasury yields (the yield on 30-year U.S. Treasuries reached 4.83% on May 30, 2025).

In addition, the "yen carry trade" (borrowing low-interest yen to invest in high-yield U.S. bonds) created by Japan's long-term low interest rate environment is enormous, estimated to involve trillions of dollars. The rise in JGB yields made the carry trade less attractive, triggering the "carry trade unwinding", which led to a return of funds to Japan and an appreciation of the yen (USD/JPY fell from 160 to 157.75 in May 2025). This may reduce liquidity in the U.S. stock market, which is related to the decline in U.S. stock trading volume by about 5% in May 2025, as quantitative funds often borrow the yen to invest in U.S. stocks. A further reduction in Japan's holdings of U.S. bonds, coupled with the need to refinance $8 trillion of U.S. debt, could force the Fed to intervene (e.g., restart quantitative easing), increase money supply, push up inflation expectations, and further raise U.S. Treasury yields, creating a vicious circle.

Market Expectations and Investment Environment

The zero interest rate and quantitative easing policies from 2010 to 2022 (with the Federal Reserve's balance sheet increasing from 1 trillion to 9 trillion USD) have shaped an unusually low interest rate environment, while the current 5% yield on government bonds is close to historical norms ("A History of Interest Rates" shows that the average interest rate over the past 5000 years is about 4%-6%). The market needs to adjust its expectations for low rates and accept the "456 market": cash (money market funds, treasury bills) has an annual return of about 4%, investment-grade bonds (including government bonds, corporate bonds, mortgage-backed securities) about 5%, and the stock market (S&P 500) about 6%. The total return on the stock market in 2024 is close to zero (as of the end of May), significantly lower than the 25% in 2023, reflecting high valuations (the S&P 500 price-to-earnings ratio is about 22 times) and policy uncertainty. Investors need to accept lower returns and higher volatility, and active management strategies may outperform passive investments.

The Dominance of Retail Investors in the Stock Market

The influence of retail investors has increased significantly due to low-cost ETFs (with expense ratios as low as 0.03%-0.1%), zero-commission trading, and the popularity of social media messages. In 2024, retail investors will account for about 20%-25% of U.S. stock trading volume, up from 10% in 2010. According to JPMorgan Chase & Co., after U.S. stocks fell 1.5% on a trading day in 2025, retail accounts invested $4 billion in three hours, pushing the market higher. Retail investors are mostly young (under 40 years old) and tend to trade short-term, such as leveraged ETFs and zero-day expiration options (0DTE), accounting for about 30% of the options market. Social media (such as platform X) forms a group effect and amplifies the behavior of "buying the bottom". However, history has shown that periods of retail dominance, such as the 2000 tech bubble, are often associated with excessive speculation and the risk of a market correction.

Investment Advice

Investors should adjust their expectations and accept a return rate of 4%-6%, allocating assets according to their risk tolerance:

  • Cash

Money market funds or treasury bills offer about a 4% risk-free return, suitable for conservative investors.

  • Bonds

Investment-grade bonds (a $30 trillion market) offer about 5% returns, with a return rate of 1.5% in 2024 and 1% in 2023, exhibiting lower volatility than the stock market, making them suitable for conservative investors.

  • Stock Market

The S&P 500 is expected to have an annual return of 6%, but it may come with a volatility of 20% (such as a rebound after a decline in 2024). Actively managed ETFs (like ARK funds) or thematic investments (AI, energy) may yield excess returns, but diversification is needed to reduce risk.

  • Risk Management

The recovery time in a bear market is relatively long (13 years for the tech bubble in 2000, 18 years in 1966). Investors need to consider their life cycle and goals. Investors over 70 should increase their allocation to cash and bonds, while those under 35 can diversify risks through long-term regular investments.

  • Responding to Risks in the Japanese Bond Market

Given that fluctuations in JGB may push up US Treasury yields, it is recommended to reduce long-term US Treasury exposure and increase allocations to short-term government bonds or Treasury Inflation-Protected Securities (TIPS) to hedge against inflation and rising yield risks.

It is recommended to participate in bond and alternative asset investments through professionally managed ETFs (such as BlackRock and Pimco's fixed income ETFs), as retail investors are less competitive in the fixed income market. Market cyclicality requires investors to avoid a single strategy and focus on diversified allocation.

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The content is for reference only, not a solicitation or offer. No investment, tax, or legal advice provided. See Disclaimer for more risks disclosure.
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