Why the Fed's Next Move Could Trigger a Defensive Rally in Treasuries and Financials

The Federal Reserve's battle to anchor long-term inflation expectations is now intertwined with a corporate pricing power crisis fueled by trade uncertainty. Recent research by St. Louis Fed President Alberto Musalem and Kansas City Fed President Jeffrey Schmid reveals a precarious dynamic: businesses are grappling with tariff-driven input cost pressures, while the Fed's credibility hinges on keeping inflation expectations from destabilizing. This creates a high-stakes scenario where corporate behavior could force the Fed to tighten policy sooner than markets anticipate—and investors should be positioned defensively now.

The Corporate Pricing Power Dilemma

Businesses are caught in a vise. Tariffs, now at historic highs (with the U.S. imposing a 145% baseline rate on Chinese imports and a universal 10% global tariff), are squeezing input costs. Companies like Birkenstock and Pandora are responding by spreading price increases globally to avoid U.S. backlash, but this risks igniting inflation in Europe and the U.S. alike. .

Musalem's research underscores that while long-term inflation expectations remain “broadly anchored” at 2%, short-term expectations are volatile. If firms pass rising costs to consumers broadly—and not just in isolated sectors—the Fed's patience could snap. A surge in inflation expectations would force the central bank to tighten policy aggressively to preserve credibility, as seen in the 1970s.

Trade Uncertainty: The Hidden Inflation Catalyst

Schmid's analysis of trade policy uncertainty (TPU) shows how geopolitical risks are stifling global supply chains. Firms are delaying investments, rerouting production, and contending with retaliatory tariffs from allies like Canada (25% on $41.6B of U.S. goods) and China (125% tariffs). This isn't just a logistical headache—it's a recipe for inflation.

The July 2024 study on Chinese firms post-WTO accession illustrates how reduced TPU unlocks demand for imported inputs. Today, the reverse is true: rising TPU is deterring firms from global sourcing, forcing costlier alternatives. This “trade pessimism tax” could push core inflation above 2% for longer, leaving the Fed little choice but to raise rates further.

The Fed's Dilemma: Hawkish or Hesitant?

Musalem's baseline scenario assumes the Fed maintains restrictive policy until inflation converges to target. But Schmid's work highlights a darker path: if TPU fuels persistent cost pressures, the Fed may have to abandon its “look-through” approach. A loss of inflation credibility could force a Volcker-style crackdown, with severe market fallout.

The Fed's credibility is its most potent tool. If long-term expectations decouple from 2%, the central bank's options narrow to brute-force rate hikes. Investors who ignore this risk are gambling with their portfolios.

Positioning for Defensive Outperformance

The writing is on the wall: Treasuries and financials are the best hedges against Fed hawkishness.

1. Treasuries: Long-dated bonds (e.g., the 10-year Treasury) will rally as the market prices in a prolonged tightening cycle. .
2. Financials: Banks like JPMorgan (JPM) and Goldman Sachs (GS) benefit from steeper yield curves, as higher rates boost net interest margins. The Financial Select Sector SPDR Fund (XLF) tracks this sector.

Avoid sectors tied to cyclical growth, such as industrials and tech. Even defensive staples like consumer goods (KHC, PG) face margin pressure from input costs.

Conclusion: Act Now—Before the Fed Acts

The Fed's next move isn't just about data—it's about corporate behavior and geopolitical reality. Firms' struggles to contain costs and the Fed's inflation credibility are on a collision course. Investors who pivot to Treasuries and financials now can capitalize on the inevitable sell-off in rate-sensitive assets when the Fed's hand is forced.

The clock is ticking. The question isn't whether the Fed will tighten further—it's whether you're positioned to profit before the market catches up.