Deutsche Bank says markets remain highly sensitive to U.S.-China trade developments

[Divided Forces - United States and China Puzzle Pieces Separated]

Wall Street witnessed a sharp sell-off on Friday as the U.S. and China once again seemed to be at loggerheads when it came to trade policies.

Deutsche Bank noted that the market sensitivity to the trade developments between the two countries further highlighted the importance of the May trade truce between Washington and Beijing. The truce had earlier eased fears of an economic downturn. "So any signs of reversal will naturally be met with a risk-off move," Deutsche Bank's Henry Allen said.

"For instance, we can see from Polymarket’s 2025 recession probability that the truce was a key turning point, and the announcement led the S&P 500 to surge +3.26% that day, whilst US HY spreads tightened 38bps," Allen added.

Earlier in April, recession fears had gripped the markets after the Liberation Day tariffs; however, tensions eased a bit after the U.S.-China trade truce.

On May 12, the U.S. and China agreed to a significant reduction [https://seekingalpha.com/news/4446216-trade-tensions-subside-as-us-and-china-agree-to-slash-tariffs-for-90-days] in tariffs on each other’s goods for 90 days. Each country will cut tariffs by 115%, with the U.S. cutting tariffs on Chinese imports from 145% to 30%, and China cutting tariffs on U.S. imports from 125% to 10%. The tariff reductions are set for an initial period of 90 days.

On Friday, Trump threatened higher tariffs on China, saying it had "become very hostile," sending letters to other countries wanting to "impose export controls."

However, Trump posted Sunday that "it will all be fine" and described Chinese President Xi Jinping as “highly respected” and suggested that both nations want to avoid economic pain, writing that the U.S. “wants to help China, not hurt it.”

"More broadly, one framework to understand this year’s market moves is to think about recession probabilities, which induced a huge selloff and recovery as that recession was priced in and out again. So anything that meaningfully raises those probabilities is likely to cause an outsized market reaction," Allen said.

Deutsche Bank also noted that the announcement showed that the tariffs have not yet settled, and given their sequential implementation, they are not a one-off price shock either.

U.S. tariffs have been continuously implemented throughout the year, with levies raised on Canada and Mexico in March, a global 10% baseline taking effect in April, and additional duties on copper and pharmaceuticals arriving later.

"In other words, the inflationary impact is continuing to filter through and will keep doing so into 2026 as firms adjust their prices. This is important for inflationary psychology too, as repeated tariffs will help to keep inflation expectations higher, and leading indicators are already pointing higher," Allen said.

Allen noted that policy remains reactive to market stress, and a key reason for the market's resilience is that the sell-offs act as a "consistent brake on policymakers."

"After all, sell-offs create bad headlines, cause economic damage via negative wealth effects, and can generate unpopularity. So there are large incentives to avoid sell-offs, and we’ve seen numerous policy reversals under market pressure, including the 90-day tariff extension in April after Liberation Day," Allen said.

Wall Street looked set to shrug off the sell-off on Friday, with stock index futures rising sharply on Monday, as President Donald Trump downplayed the country's trade tensions with China.

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