U.S. bond investors are heavily betting that Trump's tariff policy will drag down the economic growth of the world's largest economy, thus forcing the Federal Reserve to cut interest rates.

On the eve of the release of Friday's non-farm employment report, the money markets have priced in nearly four cuts of 25 basis points by the Federal Reserve in 2025, one more than the expectation prior to Trump's large-scale tariff announcement last month. Meanwhile, Wednesday's positions data showed that short-term Treasury long positions continue to rise, reflecting that the market believes the impact of Trump's comprehensive tariff plan on economic growth will outweigh its inflationary push.

However, expectations for a sharp economic slowdown still need to withstand continuous testing by real data: after manufacturing survey data released on Thursday exceeded expectations, traders hurried to unwind some rate cut bets. This tense atmosphere has focused the market on April's non-farm employment report - this data will reveal the potential impact of tariff uncertainty on the labor market for the first time.

'As market participants weigh the (tariff) impact on Federal Reserve policy, concerns over significant weakness in growth have completely offset the short-term inflation upside risks from the tariffs,' said Lee Hardman, a strategist at Mitsubishi UFJ Financial Group (MUFG).

The core issue facing bond investors is whether the pessimism reflected in recent surveys will seep into core indicators such as employment and consumer spending. Data shows that the U.S. consumer confidence index fell to a near five-year low in April, while the manufacturing activity index contracted at the largest rate in five months.

Signs of weakness in the U.S. economy have driven up short-term Treasury bonds this month, causing the Treasury yield curve to steepen. The yield on the 2-year and 5-year Treasuries has exceeded that of the 30-year Treasury, creating the largest gap since early 2023.

The U.S. Treasury yield curve is steepening

In addition, the uncertainty surrounding trade policies has made the economic outlook more complex. The U.S. is in negotiations or planning discussions with major trading partners, but the final timing and scope of tariff implementation remain unclear. On Friday, China stated it is evaluating the possibility of restarting trade negotiations, while Japan indicated discussions may accelerate in mid-May.

Japanese Finance Minister Katsunobu Kato even hinted at possibly using its large Treasury holdings as a bargaining chip, although the authenticity of his statement remains in question. As the largest overseas holder of approximately $1.1 trillion in U.S. Treasuries, the movements of Japanese investors are closely watched by the market.

Data challenges are coming

Currently, Federal Reserve officials are awaiting the release of 'hard data' while remaining vigilant about the potential inflationary impact of tariffs. Federal Reserve Governor Waller stated last week that if the unemployment rate rises significantly (potentially triggered by more aggressive tariffs leading to corporate layoffs), he would support a rate cut.

'A slowdown in the labor market is a necessary condition for the Federal Reserve to continue its easing process,' said Gargi Chaudhuri, Chief Investment Strategist for the Americas at BlackRock. She believes that even if the April employment data is weak, it is only 'one step towards that direction (rate cuts)', the Federal Reserve needs to see more data to confirm.' They must consider all data; a single month of weakness is insufficient to signal a restart of the rate-cutting cycle.'

The Federal Reserve is currently in a quiet period ahead of its May 6 interest rate meeting. Traders are betting on four 25 basis point cuts in 2025, with the first cut possibly starting in June. In mid-March, the market was only pricing in two cuts for the year.

Pacific Investment Management Company (Pimco) portfolio manager Michael Cudzil said on Wednesday, 'If we see a substantial turn in the economy, this will pave the way for the Federal Reserve to take action later this year - likely strong action.' Cudzil revealed that Pimco is increasing its holdings of 5-10 year Treasury bonds.

Economists widely expect that April's non-farm payrolls will add 130,000 jobs (previously 228,000). However, most believe that this data has limited revealing power regarding the impact of tariffs. Even if the data is strong, investors may view it as a lagging indicator and maintain expectations of a wave of layoffs in the coming months.

Bloomberg's economic research team wrote, 'Friday's April data will be the 'last solid reading before the storm arrives.' The labor market may show clearer signs of deterioration as early as May.'

The options trading focused on non-farm event price fluctuations - the 10-year Treasury straddle expiring on Friday - currently implies a daily fluctuation of about 9 basis points in the 10-year yield, consistent with historical non-farm days.

In the U.S. Treasury futures market, open interest (the total number of unsettled contracts) has surged in recent trading days, following a sell-off triggered by Trump's tariff announcement. In the 5-year Treasury, open interest has risen to the highest level since data collection began in the early 1990s.

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