COLUMN-Tax cuts could trump tariffs, but it may be too late: Pelosky

By Jay Pelosky

April 17 - Just when there seemed to be little hope that Donald Trump would reverse his aggressive tariff plans, Mr. Market saved the day, forcing the U.S. president to reverse course. But what might be at the root of Trump’s U-turn is not concern about tanking markets, but his own tax agenda.

Last week was one of the most volatile five-day periods in U.S. equity markets over the past 60 years, according to Sentiment Trader. But the cascade of daily equity losses that followed Trump’s April 2 tariff announcement wasn’t enough to force the president to back down. Instead, trouble in the bond market appears to have ultimately forced him to retreat and pause his ‘reciprocal’ tariffs for 90 days.

Indeed, Treasury selling intensified last week, as fears grew that a tariff-driven inflation spike and escalating trade war would lead to a U.S. recession and further expansion of the already-gaping U.S. deficit.

The dollar joined the party, with the DXY index collapsing to under 100 from a high of 110 late last year. Bonds’ usual role as a hedge against falling stocks clearly wasn’t working, raising fears of bigger losses ahead and concerns about market functioning.

Trump’s tariff delay offered a reprieve, but it proved temporary.

That shouldn’t be surprising, as a 90-day pause doesn’t provide any clarity. Furthermore, the average tariff rate is now estimated to be roughly 25%, the highest since the early 1900s and among the highest in the world.

And Morgan Stanley’s post-pause U.S. growth forecast expects the economy to expand by only around 0.5% this year and next, with inflation running at roughly 4% by yearend and the unemployment rate rising to approximately 5% by 2026.

Finally, last week U.S. House Republicans advanced legislation to significantly increase the deficit, and news broke that Trump was seeking Supreme Court approval to fire top agency officials, generating speculation that Federal Reserve Chair Jerome Powell could be at risk.

There is no hard evidence that this fear is justified. But with 10-year Treasury yields well above their ‘Liberation Day’ levels and stocks still well below their pre-tariff heights, the last thing markets need to worry about is the potential for a politicized Fed.

Ultimately, for the week overall, the 10-year Treasury bond rose by over 50 basis points, while the DXY fell more than 3%, an extremely rare and worrisome combo.

CUT, CUT, CUT

So will the bond market continue to be a moderating force? Likely yes, because of another major factor pushing Trump to reverse course: namely, tax cuts.

Reducing taxes is a key focus of Trump 2.0, much as it was for Trump 1.0. The president confirmed this early on in his statement to Davos, which contained a promise for “the largest tax cut in American history, including massive tax cuts for workers and family and big tax cuts for domestic producers and manufacturers”.

Treasury Secretary Scott Bessent reiterated this, stating in February “one of the big things that this administration wants to do is make the 2017 Tax Cuts and Jobs Act permanent."

Any further tax cuts would likely lead to bigger deficits, as offsetting savings from the efforts of the Department of Government Efficiency are currently estimated to be only around $150 billion, a far cry from the $2 trillion originally touted.

These deficits will thus need to be debt financed, requiring a docile Treasury market, which may be why it was the bond market selloff that did the trick last week.

One could argue that the need for income to fund tax cuts is actually a primary driver of the tariffs, as Trump has suggested that this revenue could replace some income tax.

But let’s look at what we know: when tariffs created dysfunction in the bond market, tariffs had to be walked back. So even if the desire for tax cuts was partly behind the initial tariff push, Trump’s recent actions suggest he will prioritize maintaining the ability to finance these cuts via debt over potential tariff income.

But U.S. assets no longer appear to be a safe harbor in times of stress, for the moment at least, as the White House itself is the source of the troubles. That is not a good look for an administration planning to ratchet up the deficit, issue more Treasuries, and, thus, make itself more dependent on foreign investors.

So Mr. Market may have made Trump blink, but he can’t make investors unsee all the damage to U.S. credibility that has been done in recent weeks.

(The views expressed here are those of the author. Jay Pelosky is the Founder and Global Strategist at TPW Advisory, a NYC-based investment advisory firm. You can follow Jay on Substack at The Tri Polar World).