Japan Trade Deal Means Less Inflation. Bonds Are Pricing It In.

U.S. tariffs on Japan are turning out to be lower than feared. Above, a factory in Hokkaido in 2023. (Soichiro Koriyama/Bloomberg)

Expectations of where inflation will be in the coming years, already declining, have taken a further dive as a result of the trade agreement between the U.S. and Japan.

So-called break-even inflation rates, which reflect the bond market’s expectations of how fast prices will rise, are at 2.7118% and 2.483%, respectively, for the next two and five years. Those values compare with peaks of 2.7669% and 2.5441% on Thursday. Both were multimonths high.

Trade deals make a difference. Lower average effective tariffs mean U.S. businesses might pay less for imports, potentially allowing them to raise prices for consumers less than they would have.

It matters because the amount of tariffs paid is significant. In June, the U.S. pulled in $27 billion in custom duties, a 302% jump from a year ago, the Treasury monthly budget statement shows. The lower inflation turns out to be, the more likely the Federal Reserve is to cut interest rates, helping to reduce the cost of mortgages, among other debt, and further boosting the S&P 500 .

Investors expect a spate of agreements before Aug. 1, when the Trump administration plans to impose tariffs as high as 50% on some imports. The Japan deal, unveiled on Tuesday evening, was a big one.

Traders didn’t expect a deal soon, given that Japan’s dominant Liberal Democratic Party lost its majority in the Upper House of Japan’s parliament over the weekend. Speculation that Prime Minister Shigeru Ishiba will resign are rife, but he remains in the job.

While investors had assumed Japan would face 20% levies, given the White House recently announced 19% tariffs on Indonesia and the Philippines. Japan managed a flat tariff of 15% across all products. That includes autos and parts, a critical sticking point.

In return, the country is opening up some sectors for imports from the U.S. and offering $550 billion of investment in the U.S. President Donald Trump had earlier threatened to impose a 25% tariff in a letter to the Japanese government.

The lower tariff for Japan “is helping bring down assumed tariff rates on other countries,” wrote Dennis DeBusschere, president of 22V Research. “Some investors have pointed out that it is likely Canada and Mexico tariffs will be reduced as a result. That may or may not happen, but we get the logic.”

Macquarie strategist Thierry Wizman sees potential benefits elsewhere. “If Trump has, in fact, loosened up on dealmaking, the set-up is better for” South Korea and the European Union, with a 15% rates in the cards for the latter and potential exemptions for autos, he wrote in a research note. The EU, a 27-nation bloc, is the U.S.’s biggest commercial partner.

Even before the Japan deal, expectations for inflation were declining. The University of Michigan’s July Survey of Consumers, released on Friday, showed that consumers’ expectations for inflation are at the lowest since February, a positive sign because those expectations can affect actual inflation levels.

The caveat here is that tariffs aren’t limited just to countries. The Trump administration has already imposed 50% levies on steel and aluminum, and one on copper might take effect on Aug. 1. The Department of Commerce recently announced investigations into the national-security effects of imports of products like polysilicon and drones. Timber and lumber and semiconductors have been under investigation for months.

Trump could levy tariffs on those sectors if the investigations determine these imports impair national security.

Aichi Amemiya, senior economist at Nomura Securities, described the U.S.-Japan deal as a “slightly dovish development, posing some downside risks to our updated tariff assumptions.”

Before the Japan deal, Amemiya and his team had ratcheted up their expectation for the average effective tariff rate to 19.5%, from 15.2%. He expects 25% sector-specific tariffs on products already under investigation by the Commerce Department, and average country-specific tariffs of 20%. For context, in 2022, the average applied U.S. tariff across all products was 1.5%, according to the World Bank.

“Overall, the totality of information on trade negotiations makes us comfortable” sticking with those forecasts, he told Barron’s.

Write to Karishma Vanjani at karishma.vanjani@dowjones.com.