Financial markets face a challenging outlook despite the US and China agreeing to reduce extra tariffs to 30% and 10% respectively and the US Court of International Trade ruling against some of the Trump administration’s new tariffs.

Importantly, US new baseline 10% tax on all imports remains in place as does the Trump administration’s 9 July deadline to impose further sweeping reciprocal tariffs unless dozens of countries agree to new trade deals.

We thus see three key risks to the economic outlook.

First, higher US tariffs will result in a supply shock to the US economy. We expect US growth to halve this year, inflation to rise and the Fed, faced with stagflation, to limit interest rate cuts in 2025 to ensure inflation does not become unmoored from its 2% target.

Second, the rest of the world is set to suffer a demand shock from US tariffs. But we expect interest rate cuts and fiscal stimulus in Europe and Asia to cushion growth.

We therefore see activity weakening in major emerging economies ‒ including China and India ‒and staying subdued in the Eurozone and UK as our table of GDP growth forecasts below shows. But we do not see severe crises this year, as governments in the rest of the world loosen monetary and fiscal policies and strike trade deals with the US to reduce the Trump administration’s new tariffs.

Third, the Trump administration’s volatile economic, fiscal, trade and foreign policies are undermining faith in US assets. We thus see the US Dollar and US Treasuries (UST) weakening over the long term, as investors rotate to Europe and Asia. For example, we think 10Y UST yields will settle at higher levels around 5% and the greenback will fall further to 1.23 against the EUR over the next 12 months.

US: A patient Fed

This year, the Federal Reserve has paused its interest rate cuts while it waits for more clarity on the economic outlook. In May, the Federal Open Market Committee (FOMC) left its fed funds rate at 4.25-4.50% for the third meeting in a row and signalled it remains in no rush to change interest rates while awaiting clarity on the Trump administration’s tariffs and fiscal policies.

The FOMC’s meeting statement was altered to highlight uncertainty had increased since President Donald Trump’s “Liberation Day” tariff announcements on 2 April: ‘uncertainty about the economic outlook has increased further.’

The FOMC also warned that risks had increased to its twin goals of achieving stable prices and maximum employment: ‘the Committee is attentive to the risks to both sides of its dual mandate and judges that the risks of higher unemployment and higher inflation have risen.’

Third, Chairman Jerome Powell stressed the Fed was well positioned to keep interest rates at current levels while waiting for more clarity on the outlook before acting: ‘we don’t think we need to be in a hurry. We think we can be patient. We are going to be watching the data. The data may move quickly or slowly. But we do think we are in a good position where we are to let things evolve and become clearer in terms of what should be the monetary policy response.’

We continue to see the Fed leaving interest rates unchanged for most of this year as steep US tariffs cause inflation to rise. We expect only one 25bps rate cut at most, which will be likely in 2025.

We thus keep our view that with little Fed rate cuts, higher inflation from steeper tariffs and a worsening US budget deficit, long-term UST yields are likely to rise sharply. At the same time, we continue to see the USD weakening further as global investors recoil from US policymaking.

Our key macroeconomic forecasts for the fed funds rate remain above 4.00% throughout 2025, for 10Y UST yields to increase to 5.00% and for the EUR to reach 1.23 over the next 12 months.

China: Will slow but not falter under US tariffs

China’s economic outlook has improved this year after two key developments in May.

First, following negotiations in Switzerland, the US and China agreed to slash the extra tariffs each country has imposed on each other this year. The 90-day reprieve will last until 10 August. But the trade truce has scaled back tariffs much earlier and deeper than investors had expected.

This year’s additional US tariffs on Chinese goods will fall from an extreme 145% to 30%, comprising the 20% additional tariffs imposed by the Trump administration to deter fentanyl supplies, and the new 10% baseline Washington set in April on all US imports. Similarly, China’s extra tariffs on US exports will fall from 125% to 10%. Thus, overall US tariffs on Chinese goods now stand around 40% and China’s on US exports just under 30%.

Second, the People’s Bank of China (PBoC) announced its first interest rate cut since September. Its 7-day reverse repo rate will fall 10bps to 1.40%. Reserve requirement ratios (RRR) will also fall 50bps. Large banks will thus need to retain 9.00% of deposits from 9.50% before.

The combination of an early trade truce and early rate cuts supports our view that China’s economy will slow this year but not falter under US tariffs. We thus keep our forecast for GDP growth to ease from 5.0% in 2024 to 4.2% in 2025.

Europe: Easing monetary policy

We expect the European Central Bank (ECB) and the Bank of England (BoE) to keep on reducing interest rates this year to support lacklustre GDP growth of around 1.0% in both the Eurozone and the UK.

In contrast to the US, which is set to suffer higher inflation due to the supply shock from its tariffs, the Eurozone and the UK will see inflation ease from the demand shock of lower US purchases of Europe’s exports. We therefore expect the ECB and the BoE to keep cutting interest rates this year to 1.75% and 3.75% respectively to the benefit of Europe’s financial markets.

At the same time, we expect the falling USD globally to cause the EUR and GBP to keep rallying 1.23 and 1.44 respectively over the next 12 months. We thus see stronger domestic currencies also causing the ECB and BoE to keep lowering interest rates to cushion growth from higher US tariffs this year.

Japan: A cautious BoJ

In contrast to the Fed, PBoC, ECB and BoE, the Bank of Japan (BoJ) is the one major central bank that has been raising interest rates over the past year, helping the JPY recover from its four-decade lows of 162 against the USD reached in 2024.

We expect the BoJ will keep on gradually raising rates in 25bps steps roughly once every six months. Currently, the BoJ’s overnight call rate is still very low at just 0.50% while core inflation has been above its 2% target since 2022. But at its latest meeting on 1 May, the central bank gave no indication when it would next lift interest rates given the uncertain outlook for global trade.

We expect the BoJ to keep its rate hikes paused until Japan signs a trade deal with the US. Once, the BoJ has clarity on exports, we think it will hike again enabling the JPY to rise further to 132 against the USD over the next 12 months.