SYDNEY (REUTERS) - Asian shares sank and sovereign bonds surged on Friday (May 31) as investors feared US President Donald Trump's shock move to slap tariffs on Mexico risked tipping the United States, and maybe the whole world, into recession.
The outlook darkened further when a key measure of Chinese manufacturing activity disappointed for May, questioning the effectiveness of Beijing's stimulus steps.
Markets moved aggressively to price in deeper rate cuts by the Federal Reserve this year, while bond yields touched fresh lows and curves inverted in a warning of recession.
Washington will impose a 5 per cent tariff from June 10, which would then rise steadily to 25 per cent until illegal immigration across the southern border was stopped.
Trump announced the decision on Twitter late Thursday, catching markets completely by surprise and sparking a rush to safe harbours.
"The threat of US tariffs on Mexico to take effect inside two weeks is a sharp blow to investor sentiment," said Sean Callow, a senior FX analyst at Westpac.
"Mexico is the US's largest trading partner and a flare-up in trade tensions was definitely not on the market radar," he added. "This is obviously a major setback for CAD, MXN and the thousands of US businesses that use Mexican-made products."
Yields on the 10-year Treasury note quickly fell to a fresh 20-month low of 2.18 per cent, while the US dollar jumped 1.8 per cent on the Mexican peso. E-Mini futures for the S&P 500 sank 0.9 per cent, leading Asian bourses lower.
Japan's Nikkei fell 1.1 per cent, to be down 6.9 per cent for the month so far. MSCI's broadest index of Asia-Pacific shares outside Japan eased 0.2 per cent and was off a hefty 7.7 for the month.
Investors clearly feared that opening a new front in the trade wars would threaten global and US growth, and pressure central banks everywhere to consider new stimulus.
On Thursday, Federal Reserve Board of Governors Vice Chair Richard Clarida had said the central bank would act if inflation stays too low or global and financial risks endanger the economic outlook.
"What the Clarida's comments have done is clarify in many people's minds the answer to the questions of whether low inflation proving more than transitory would itself be enough to get the Fed to ease - the answer appears to be 'yes'," said Ray Attrill, head of FX strategy at National Australia Bank.
"That served to reinforce prevailing market expectations that the Fed will be easing in the second half of this year."
Indeed, the case that the inflation slowdown was temporary took a hard blow when the core personal consumption expenditures (PCE) index, the Fed's favoured measure of inflation, was revised down sharply to 1 per cent for the first quarter, from 1.3 per cent.
The increase was the smallest in four years and pushed inflation further below the Fed's 2 per cent target.
Trump's tariff threat only added to the dangers and the market further narrowed the odds on Fed easing this year. Futures imply 43 basis point of cuts by year end in the current effective funds rate of 2.38 per cent.
YIELD INVERSION = RECESSION RISK
Bonds extended their bull run with 10-year Treasury yields now down a steep 32 basis points for the month and decisively below the overnight funds rate.
Such an inversion of the yield curve has presaged enough recessions in the past that investors are wagering the Fed will be forced to ease policy just as "insurance".
Yet Treasuries are hardly alone in rallying, with bond yields across Europe either at or near record lows. Yields in Australia and New Zealand are also hit an all-time trough on expectations of rate cuts there.
Those declines have kept the US dollar relatively attractive from a yield point of view and it was trading near a two-year high against a basket of currencies at 98.119.
The euro was huddled at US$1.1130, having shed 0.75 per cent for the month. The safe haven yen has been faring better and was holding a small monthly gain on the dollar at 109.24.
Sterling was poised for the biggest monthly drop in a year as the imminent departure of Theresa May as prime minister deepened fears about a chaotic divorce from the European Union.
The pound was last at US$1.2611 and nursing a 3.2 per cent loss for the month so far.
In commodity markets, spot gold edged up 0.2 per cent to US$1,291.64 per ounce.
Oil prices added to losses on fears a global economic slowdown would crimp demand.
US crude was last down 57 cents at US$56.02 a barrel, while Brent crude futures lost 60 cents to US$66.27.