Traders are expecting a rate cut as soon as next month as Trump's trade wars escalate

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Traders watch President Donald Trump's announcement on steel and aluminum tariffs on the floor of the New York Stock Exchange (NYSE) ahead of the closing bell, March 8, 2018 in New York City.

  • As President Donald Trump escalates trade tensions on multiple fronts, the market is increasingly expecting that the Federal Reserve's next policy move will be a rate cut.
  • Economists say the burden of existing and threatened tariffs fall on American businesses and consumers.
  • Nearly half of investors forecast the central bank will lower borrowing costs at its July meeting.

As President Donald Trump's escalating trade wars threaten to upend growth in the largest economy and elsewhere, the market is increasingly betting that lower borrowing costs are on the horizon.

The probability that the Federal Reserve will cut its benchmark interest rate at a policy meeting in July has jumped to about 60%, according to CME Group's FedWatch tool. Those odds have increased steadily in recent days, along with the threat of broader tariffs on some of the US's biggest trading partners.
"It's the growing prospect of ever-higher tariffs and retaliation that intensified through May that has pushed investors out of equities and into bonds," said Luke Tilley, the chief economist at Wilmington Trust.

"The resulting impact on yields … may end up forcing the Fed's hand to cut rates at one of the next few meetings in 2019," added Tilley, a former staffer at the Philadelphia Fed. On Monday, the yield on the 10-year Treasury note fell to 2.09%, its lowest since September 2017.

The Federal Open Market Committee has signaled it's in no rush to adjust its benchmark interest rate from the current target range of 2.25% to 2.5%.

But deteriorating financial conditions could change that. At a presentation in Chicago on Monday, St. Louis Federal Reserve President James Bullard acknowledged trade risks and said that a rate cut "may be warranted soon."

Research suggests American businesses and consumers bear the brunt of protectionism. Morgan Stanley said this past weekend that if Trump follows through with threats to slap broader tariffs on China and Beijing responds in kind, the US could enter a recession within a year. "My recent conversations with investors have reinforced the sense that markets are underestimating the impact of trade tensions," Chetan Ahya, the chief economist at Morgan Stanley, wrote in a research note.

Trump has also cast uncertainty on trade relationships with other major US trading partners. Last week, the president threatened to levy tariffs on all products from Mexico if the US ally didn't take steps to stem the flow of migrants across the southern border.

"In our view, if the US is willing to impose tariff and non-tariff barriers on China and Mexico, then the bar for tariffs on other important US trading partners, including Europe, may be lower than we previously thought," said Michael Gapen, an economist at Barclays.

Trump has argued the US would gain leverage in trade negotiations if the Fed were to lower interest rates. While the central bank operates independent from political interests, the president pressured officials to offer the economy a boost ahead of the 2020 elections.

"China will be pumping money into their system and probably reducing interest rates, as always, in order to make up for the business they are, and will be, losing," he wrote on Twitter last month. "If the Federal Reserve ever did a 'match,' it would be game over, we win! In any event, China wants a deal!"