A Framework for Navigating Structural Uncertainty

Summary

• Rather than ‘an economic nuclear winter’ the endpoint for the US economic trajectory is likely a deal of sorts with trading partners. The US can get there with or without a recession.
• I see only a 20% chance of getting there without recession largely due to a lack of consensus among Trump administration officials. In such an instance, the yield curve would flatten.
• My base case (55% chance) is a recession that would align with the post-WWII median. In such an instance, the curve would steepen
• Because the dollar is losing its safe haven status and because the prospects for fiscal consolidation are unclear, I see a 25% chance of a deeper recession due to a Treasury market crisis. In such an instance, the curve would steepen more than in my base case.
• I intend to update my probabilities based on new information and will publish regular updates.

Market Implications

• I expect 150bp in Fed cuts, most of them in 2025, against markets expecting 90bp.

Uncertainty Has Turned Structural

In Chair Powell’s interview yesterday, former RBI governor Rajan highlighted the current extraordinary uncertainty, ‘The worry today is not just about immediate policy uncertainty, but an entire change in the U.S.’s economic philosophy, not just policy uncertainty, so to speak, but structural uncertainty.’

Here, I propose a framework to navigate this uncertainty that builds on the three macro scenarios I developed last week. Read more about this here.

I start by describing where I see the economy going long term. Unlike CEO Bill Ackman, I do not believe the US is headed for an ‘economic nuclear winter.’ This is because the elimination of the current account deficit is unfeasible unless the US becomes an autarkic, centrally planned economy. This is impractical, both economically and politically.

The endpoint of the current economic trajectory is more likely to be a series of deals with our main trading partners. The administration has already been contacted by 70 countries seeking deals and President Trump has reported ‘big progress’ in negotiations with Japan.

This endpoint can be reached directly, which is the better scenario I discussed last week (Table 1) or indirectly, through a recession that would lead to a change in economic policy towards the good scenario, possibly involving political change.

The current series of policy turns and twists suggests persistent uncertainty and hence my base case scenario is for a recession of severity similar to the post-WWII median.

However, risk exists that the recession could turn out worse than my base case, most likely because of current bond market instability. A Treasury crisis would tighten financial conditions to such an extent the Fed may be unable to offset. In such an instance, the recession would be deeper and last longer than in the base case.

Table 1 summarizes my three scenarios. Fed easing depends on the extent of second-round effects from the tariffs on inflation, which are strongest in the better scenario, and weakest in the worse scenario as a deep recession reduces businesses pricing power. I have added curve scenarios, based on recent curve responses to monetary policy surprises. I have also attached probabilities to each scenario, which I now discuss.

Only 20% Chance of Avoiding Recession

In my better scenario, the administration closes deals with its key trading partners within the next couple of months, and sticks to them, which lowers policy uncertainty (Chart 1). Also, average effective tariffs are lowered to about 10% from currently 25%, which reduces the hit to real household income and the severity of the forthcoming manufacturing recession.

In this scenario tariffs are higher than under the Biden administration, but non-tariff barriers are lowered and DI into the US increases. Trump has already announced a series of deals. Paradoxically, this could increase the openness of the US economy that had flattened out after the GFC (Chart 2).

Whether the trade deficit falls is unclear as imports and exports increase. Most importantly, the administration’s plans for the budget deficit, the main driver of the current account deficit, remain unclear (Chart 3).

With these policies, the current economic weaknesses self-correct, the economy avoids recession, and businesses keep substantial pricing power. This brings about substantial tariffs second-round effects, which preclude Fed easing and the yield curve flattens (Chart 4).

I am only assigning a 20% risk to this scenario because of the administration’s mixed messages that partly reflects disagreement among Trump advisors. In addition, Congress is not playing its role. Tariffs are to become a substantial source of tax revenues and therefore ought to be decided by Congress, which holds power of the purse. Instead, several lawsuits against the administration’s tariffs have been launched but these could take time to work their way through the courts.

Median Severity Recession: 55% Probability

In my base case scenario, policy U-turns continue and uncertainty remains at levels consistent with recession. Deals with key partners are not concluded for another quarter or so and/or are not observed. Average effective tariffs remain near the current 25%. Due to the high uncertainty, business environment DI deals fail to materialize.

As a result, confidence continues collapsing, household and business spending is on hold, and tariffs hit households’ real income (Charts 5-6). Eventually, demand weaknesses spread to the labour market and become self-sustaining (Chart 7).

In this scenario, the US goes through a recession of severity aligning with the WWII median. A key reason is that, by contrast with the GFC, private sector balance sheets are in reasonably good shape.

The recession is likely to start in Q1 or Q2 and last three quarters. This limits businesses’ pricing power, dampens second-round tariff effects, and allows the Fed to cut. However, with inflation above target and risks of second-round effects, the Fed is likely to be reactive rather than proactive. The first cut could therefore come around mid-year.

Because I expect the Fed to cut about 150bp in 2025, more than the 90bp currently priced in, the curve steepens.

This is my base case scenario, largely due to reasons discussed above. The recession leads to policy changes as Trump loses popularity in the polls (Chart 8). Nevertheless, the policies put the US on a lower long-term growth trajectory, damage US global credibility as well as global institutions and growth.

Severe Recession: 25% Probability

In the worse scenario, the contractionary impact of tariff policy is augmented by a Treasury market crisis. There are signs the Treasury market is losing its safe haven status (Charts 9-10). This could reflect the US unilaterally changing the rules governing global trade in goods. Global capital markets could be next. For instance, Steve Miran, the head of the Council of Economic Advisers, has suggested taxing foreign holders of Treasury securities.

If the Treasury market loses its safe haven status, the cost of funding the budget deficit will rise and an already unsustainable deficit will become more unsustainable. The worsening of public debt dynamics would leave the US open to a loss of confidence, especially from foreign investors who may not take kindly to the new US trade policies.

Such a crisis could translate into a sharp tightening of financial conditions that the Fed may be unable to fully offset. This would add to the duration and depth of the recession in the base case scenario.

With a deep recession, the risks of second round tariff effects would be limited and the Fed would be able to fully focus on the employment leg of its mandate. Based on the experience of the 2000s, the Fed could cut 300bp. The curve would steepen by more than in the base case due to deeper Fed cuts and sovereign risks getting priced in on the long end.

The damage to long-term US growth would be stronger than under the base case.

My probability for this scenario is 25%, greater than the better scenario, largely because prospects for fiscal consolidation are unclear. The Senate has changed the budget rules so the extension of the TCJA tax cuts does not need to be funded. Also, it is unclear whether the additional tax cuts planned by Congress will be fully funded by expenditure cuts.

A Bayesian Approach to Predicting 2025 Economic Outcomes

I intend to update my probabilities for each scenario daily, based on new information including data releases, policy decisions, tariff news, and Trump approvals (Table 2). In doing, so I am inspired by the Good Judgment Project that stresses techniques such as Bayesian reasoning, regular reviews and feedback and open-mindedness as tools to improve forecasting accuracy. I intend to publish regular updates of my probability journal.

Market Consequences

My base case scenario remains a recession starting in Q2 and lasting about three quarters, with the Fed cutting interests rates by about 150bp, mostly in 2025. This compares with markets pricing three 2025 cuts and one 2026 cut.

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