How Far Will President Trump Take Tariffs? This Key Economic Indicator Offers Clues.

President Donald Trump kicked off his presidency by repealing many of former President Joe Biden's executive orders and signing several of his own. Investors have anxiously awaited Trump's start to see which policies he prioritizes and which promises he makes good on. Few issues are being watched closer than tariffs, which Trump campaigned on.

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Trump said his administration plans to launch 25% tariffs on Mexico and Canada on Feb. 1, but more or less punted on implementing more universal tariffs or taking more prohibitive action against China. The market took this as good news indicating that Trump may proceed more cautiously than expected on tariffs.

While it's impossible to predict what will happen over the next four years, one key economic indicator may offer clues as to how far Trump will go with tariffs.

Watch Treasury yields

The market and the Federal Reserve are seemingly in a never-ending battle with inflation. The Consumer Price Index (CPI) recently peaked in 2022 after prices rose over 9% year over year. This led the Fed to raise interest rates intensely to try to rein in inflation, moves that have more or less been successful with inflation recently slowing to 2.9%. While unemployment has remained low in recent years, many in the economy have still felt the pinch as high prices have cut into their savings.

With inflation seemingly trending in the right direction, no presidential administration would want to risk reigniting inflation. However, tariffs risk doing that very thing as they increase the cost of importing goods, which can lead to higher prices, with even the Fed citing the uncertainty of these policies in its recent meeting minutes. Since the Fed's meeting in December, many have grown concerned about sticky inflation, leading to a rise in Treasury yields, an important economic indicator that investors should monitor, specifically the 10-year U.S. Treasury yield.

While Treasury yields are influenced by the federal funds rate, the market can also influence them independently. Yields have rarely been as volatile as over the last few years. Treasury yields are influenced by several factors including inflation expectations, economic growth, and more recently debt issues. As the U.S. continues to pile on debt, Treasury investors, specifically those in longer-term Treasuries, have grown concerned about the government's budget. Some view the country's fiscal situation as precarious and therefore are requesting higher yields to compensate for the elevated risk.

The 10-year yield neared 4.8% earlier this month, the highest level seen since April and up from 3.6% in late September . Luckily, core CPI, which excludes more volatile food and energy prices and is a key indicator of inflation, then came in lighter than expected, which sent Treasury yields tumbling lower, much to the relief of the market.

10 Year Treasury Rate data by YCharts

Treasury yields could play a decisive role in how bold the Trump administration gets with tariffs. Most presidents want to see the stock market perform well, and Trump is likely no exception. The stock market soared an incredible 53% from the end of 2022 to the end of 2024, and many already consider the market to be overvalued, largely due to the sky-high valuations and overconcentration of the "Magnificent Seven" stocks.

Higher Treasury yields, often used as a discount rate in valuations, make it more difficult for the market to sustain such high valuations because investors will require higher returns when they can invest money into risk-free Treasuries and make a higher return. Many experts view the 5% level for the 10-year U.S. Treasury note as an important threshold.

"Markets are spooked by the 5% level on the 10-year [yield] because it is the outer limit of an entire generation's experience with prevailing interest rates [over the past 20 years]. The last time we went past 5% was in mid-2007, and we all know how that story ends," DataTrek co-founder Nicholas Colas told Morningstar earlier this month, referring the the Great Recession that crushed the market until mid-2009 and took even longer to recover from.

How much slack will Trump have?

Obviously, no one can predict the future, and the 10-year yield breaching 5% doesn't necessarily mean we will have another Great Recession. Additionally, the yield curve is no longer inverted, meaning longer-dated Treasury yields are higher than shorter-term ones. This could point to economic expansion, which investors and the market might welcome.

Still, after years of intense inflation, I think a 10-year Treasury yield approaching 5% is still likely to spook the market. Higher yields -- and therefore higher inflation expectations -- also make it less likely that the Fed will cut interest rates further this year. Lower interest rates tend to stimulate the economy.

The lower the 10-year yield is, the lower inflation expectations are, and the more slack Trump has to implement tariffs and other potential inflationary policies without potentially overly accelerating inflation. If the 10-year yield reaches 5% or higher, Trump may proceed more cautiously on tariffs because reigniting inflation is already a strong concern at this level.

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Bram Berkowitz has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.