Bonds, Bluffs, and Brinkmanship

Game Theory & Machine Learning for Tariff Impact Scenario Planning

The economic picture has significantly worsened since our previous analysis. Even with the 90 day delay on the ‘retaliatory’ portion of the tariff, new data confirms that the average U.S. trade-weighted tariff rate has reached 24% - the highest level since 1909 and exceeding even the Great Depression-era Smoot-Hawley tariffs according to The Budget Lab at Yale. This dramatic increase from our previous models based on 18.8% tariffs requires a complete reassessment of economic projections and strategic scenarios. This is driven by the 125% tariff imposed on China.

The Economic Fallout: Deeper and More Sustained

Our regime-switching model now projects a 4.5% GDP contraction under baseline 24% tariff conditions - nearly double our previous forecast. Middle-income households face approximately $3,800 in additional annual costs according to The Budget Lab research, representing a substantial tax increase that will depress consumer spending across the economy.

The impact reaches far beyond GDP numbers:

1. Inflation Impact: The overall price level is now projected to rise by 2.3% in the short-run from all 2025 tariffs, with specific sectors experiencing much steeper increases including a 33% rise in apparel prices, 18% increase in non-clothing textiles, and 4.5% jump in food prices.

2. Employment Effects: The labor market will deteriorate significantly, with the unemployment rate rising 0.5 percentage points by the end of 2025, resulting in approximately 600,000 fewer jobs.

3. Market Impacts: Equity markets face sustained downward pressure, with our models projecting a 17% decline under the Extended Confrontation scenario, which has now become the most likely outcome.

Treasury Market Dynamics: The Strategic Wild Card

The Treasury bond market remains the critical strategic wild card. Japan and China together hold over $1.9 trillion in US Treasuries, and both have already begun reducing their holdings. Japan's recent Treasury sales have created a blueprint for how coordinated selling might impact bond markets.

Our game theory models now indicate three distinct scenarios with significantly adjusted probabilities:

1. Extended Confrontation (55% probability): Both sides dig in despite economic pain

   • US implements emergency Treasury market stabilization

   • China continues strategic Treasury sales while developing alternative economic networks

   • Both accept sustained economic contraction as the cost of strategic objectives

2. Initial Confrontation, Then Accommodation (35% probability): Market pressure forces compromise

   • Bond market volatility creates unsustainable political pressure

   • Negotiated reduction to more moderate tariff levels (10-15% range)

   • Economic damage contained but still significant

3. Bifurcated Development (10% probability): Selective decoupling

   • Strategic industries remain protected

   • Non-strategic sectors return to lower tariff regime

   • Alternative economic spheres of influence solidify

Game Theory Reveals the New Calculus

With tariffs now at 24%, the strategic payoff matrix has shifted significantly:

Values represent projected percentage changes to GDP over a 12-month period.

This matrix reveals a fundamental shift in strategic calculation. While both sides face significant economic costs under the current 24% tariff regime, China maintains strategic advantages through its ability to absorb economic pain while developing alternative economic networks. The US gains domestic industrial benefits but at the cost of larger overall economic contraction.

Non-Economic Strategic Impacts

Our analysis indicates the conflict has moved beyond purely economic considerations. China shows strategic gains in alternative economic networks and foreign influence despite GDP losses, particularly across developing markets. Meanwhile, the US benefits primarily in domestic industry growth, but these gains are increasingly offset by broader economic contraction.

Manufacturing firms are taking the most significant actions in response, with over 50% reporting plans to diversify supply chains and nearly 40% accelerating purchases in anticipation of tariffs. Furthermore, approximately 32% of manufacturing firms anticipate reducing employment due to tariff concerns.

Planning Amid Uncertainty

For organizations navigating this volatile environment, our probabilistic decision models suggest three strategic imperatives:

1. Prepare for Extended Confrontation as the base case scenario - At 55% probability, this scenario requires the most significant operational adjustments

2. Establish early warning indicators for policy shifts - Treasury auction bid-to-cover ratios and currency management signals provide critical leading information

3. Identify sector-specific impacts - The tariff burden falls unevenly across sectors, with apparel, textiles, food (especially fresh produce), and automobiles facing the most significant price increases

At SignalFlare.ai, we use probabilistic decision models to help customers consider these real-world potential impacts and develop robust contingency plans. Our updated models indicate the need for more significant adjustments than previously projected, as the economic impacts of 24% tariffs ripple through global supply chains and financial markets with increasing velocity.

Supporting Documents:

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