Absolute Return Partners’ letter for the month of March 2025, titled, “Tariffs or 2% - Should we worry or is it a storm in a teacup?”
Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man. - Ronald Reagan
The background
Last year, after president-elect (now President) Donald Trump started to make noises about raising tariffs, many Wall Street firms came out with dire predictions on the impact those tariffs would have on inflation. Fast forward to today, and the topic is still hotly debated every day, hence my decision to share my thoughts.
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Let’s begin by taking a look at US 10-year government bonds over the last 12 months (Exhibit 1). As you can see, the yield approximated 3.6% at the low point in mid-September, down from 4.7% in late April of last year. It then rose steeply and reached 4.8% in mid-January but has since fallen back and is now about 4.12% - still 50 bps above the lows last September. Such wild swings are quite extraordinary over a relatively short period of time but what does that tell you?
Exhibit 1: US 10-year Treasury bond yield
Note: As at 04/03/2025
Source: Trading Economics
First interpretation of recent events
US 10-year Treasury bond yields peaked at 4.8% in the last couple of days before the Federal Reserve Bank published its CPI report for December 2024 on the 15th of January. The CPI print was not meaningfully better than expected but obviously good enough to change investor sentiment. Since mid-January, the yield on US 10-year Treasury bonds have declined from 4.8% to 4.12% but why? The print was only marginally better than expected.
Relief rally are the two words that spring to mind. For the past four months, it had been painful watching the US Treasury market and, to many, it was only a question of how bad the December print would be. Few actually expected a positive surprise and, when it came, you could almost hear a collective sigh of relief. Prior to the print, investors had worried about quite a few things:
- tariffs;
- a tight labour market;
- continued robust consumer spending;
- a rebound in money supply; and
- renewed supply chain shortages.
I shall not enter into a discussion about these five issues (space won’t allow me) apart from emphasizing one of them, namely the tight US labour market and what it would mean for inflation, if Trump delivers on his promise to deport millions of illegal immigrants.
Why you should worry if millions of illegal immigrants are deported
Trump had two cornerstones in his political programmes when campaigning last year – international trade (“Make America Great Again”) and illegal immigrants. The prior, I plan to cover either next month or in the May letter, as I need to know how aggressive he is prepared to be vis-à-vis Europe before I write about it. The latter, deporting illegal immigrants and how that is likely to affect US inflation, will be the focus of the rest of this letter.
To begin with, my conclusion: this is a far bigger issue for inflation than higher tariffs. The combination of an already tight labour market and deportation of large numbers of immigrants is venom for price stability. The problem is that his stance on illegal immigrants (estimate to be 11 million +/-) is, to a significant degree, the reason he won the election, and that makes it almost impossible not to act decisively on the matter.
However, deporting millions of illegal immigrants is not that simple and shall require plenty of stamina, as it will take years and cost a fortune. The Colombia soap opera a few weeks ago is a prime example. Two military planes with 250 poor souls onboard were, at first, denied permission to land, following which 24 hours of hectic negotiations led to the two planes landing in Bogotá the next day. 250 as a percentage of 11 million is 0.00227%. If Washington can deport 250 people every week, it will only take 44,000 weeks or 846 years to sort out the problem. No big deal!
Illegal immigrants are everywhere in US industry (Exhibit 2) and often take the jobs nobody else wants, i.e., they fulfil an important role. I saw with my own eyes what happened to UK inflation in the aftermath of Brexit a few years ago, when we kissed farewell to large numbers of cheap labour from Eastern Europe.
Anecdotal evidence suggests that, in the US, the agricultural industry is going to be hit the hardest, but that is not backed up by the numbers in Exhibit 2. According to Goldman Sachs (the source behind Exhibit 2), the construction industry will take a much bigger hit. Having said that, I believe unauthorised immigrant workers play a more important role in the agricultural industry than you are led to believe when looking at Exhibit 2.
Exhibit 2: Proportion of unauthorised immigrant workers in the US by industry
Source: Goldman Sachs Global Investment Research
In terms of the estimated impact on inflation, it depends on how far Trump is willing to go. The Peterson Institute for International Economics has studied this and, in the paper, the research team at Peterson worked with two different scenarios:
- High scenario:
- Deporting 8.3 million unauthorised immigrant workers;
- Increasing tariffs on all US imports by ten percentage points and imports from China by 60 percentage points – with full retaliation;
- Increasing the president’s influence over the Fed.
- Low scenario:
- Deporting 1.3 million unauthorised immigrant workers;
- Increasing tariffs on all US imports by ten percentage points and imports from China by 60 percentage points – with no retaliation;
- Increasing the president’s influence over the Fed.
In other words, in the two scenarios, it is assumed that Trump will raise the tariffs the same, the only difference being whether the counterparties retaliate or not. Also, in both cases, it is assumed that Trump’s influence over the Fed will increase; however, when it comes to deporting illegal immigrant workers, the difference between the two scenarios is massive – 1.3 million vs. 8.3 million unauthorised immigrant workers to be deported.
Exhibit 3: Projected percentage point change in US CPI from baseline under two scenarios, 2024-40
Source: Peterson Institute for International Economics
Don’t pay too much attention to the actual numbers in Exhibit 3 above. There are still too many variables, making it impossible to provide a reasonably precise estimate at this early stage; however, the direction is very clear. Inflation will rise significantly.
Final few words
Donald Trump and J. D. Vance have begun to soften the tone on their plans to slay inflation. As J. D. Vance has been quoted as saying in this article in the New York Times: “Rome wasn’t built in a day. It’s going to take a little bit of time” [for grocery prices to decline].
It’s really quite simple. Under the monetary system in place today throughout the OECD, presidents (or, for that matter, prime ministers) do not have a say on monetary policy. That is set by an independent body. And God help us if they did! Having said that, the King of Debt (aka Donald Trump) would love for negative interest rates to return. This would allow him to build more casinos whilst getting paid for borrowing the capital required to do so. And it is precisely for that reason that Trump should never have a say when it comes to monetary policy.
Niels
Investment Megatrends
Our investment philosophy, and everything we do at ARP, is driven by the long-term Investment Megatrends which are identified and routinely debated by our investment team.
About the Author
Niels Clemen Jensen founded Absolute Return Partners in 2002 and is Chief Investment Officer. He has over 30 years of investment banking and investment management experience and is author of The Absolute Return Letter.
In 2018, Harriman House published The End of Indexing, Niels' first book.
