The Capital Markets team at PNC provides an analysis of the trends, news, and activity that took place in the market in Q2 2025 and looks ahead to what may be on the horizon.

Foreign Exchange[*]

Interest rate differentials have taken a back seat in the FX market as trade negotiations and the Federal Reserve are now the dominant themes. The strength in the equity market has kept consumer confidence up, supporting the current administration’s efforts in terms of global trade policy. The earlier that tariff talks are settled, the clearer the Fed’s path becomes. The Fed has had to balance its dual mandate of achieving maximum employment and stable prices against an economy that has remained resilient. This has given the Fed more time to assess the effects of elevated tariff levels but, as noted above, certainty will help rather than hypotheticals. Market consensus indicates that lower interest rates in the U.S. are likely, and there is considerable pressure on the Fed to act sooner. The timing will remain a subject of debate as inflation may be showing signs of going the wrong way.

FX trading will be keeping the following top of mind:

  • Tariffs are being used to influence not just trade, but foreign policy. This uncertainty will weigh on the dollar in the longer term.
  • What breaks first, inflation or growth?
  • Fed independence continues to be called into question. 
  • The potential ongoing rotation out of the dollar.

We cannot rule out some bouts of U.S. dollar strength, but as inflationary and fiscal concerns grow, the picture may become murkier, to the detriment of the dollar.

Taxable Fixed Income—Mortgage-Backed Securities (MBS)[**]

Agency MBS started the year with a strong performance in the first quarter, as many banks and depositories frontloaded their purchases for the year, a typical pattern. However, the second quarter brought significant volatility to the market, with tariffs bringing uncertainty to the outlook on inflation, thus delaying the Federal Reserve’s decision to cut interest rates. Agency MBS spreads widened ~25bps at the peak, along with a risk-off tone in many other markets.1 The yield curve also moved significantly, with the two-year to ten-year treasury spread steepening by ~30bps.1 The shape of the yield curve is critical for the agency MBS market, as a steeper curve helps securitized arbitrage (increases deal flow), and, more importantly, improves the outlook for funding rates for banks to purchase MBS.

As tariff rates were negotiated, and ultimately lowered, the market saw a fast recovery in risk, essentially a classic ‘V-shaped’ recovery in equities, credit, and MBS. By the end of the second quarter, MBS spreads were back to Q1 levels. 

For Q3, the focus will once again be on the timing of rate cuts from the Fed, and thus the incoming inflation and employment data that dictates the timing of cuts. Data throughout the summer has shown a surprisingly strong labor market, with unemployment rate at 4.1% and tame, but with sticky inflation.1 The MBS market continues to wait patiently for funding rates to improve, and for banks to return to a market they have been largely absent from since 2022, when the Fed began raising interest rates.   

Tax-Exempt Fixed Income[**]

After a very difficult first quarter of the year, in which there was significant underperformance relative to Treasurys and other asset classes, tax-exempt securities have stabilized and, in some parts of the curve, outperformed. The tax-exempt fixed income space continues to be dominated by the prospect of a record supply year. Supply is currently running up 15% year-over-year, and expectations continue to indicate a number upwards of $550+ billion, which would eclipse 2024 levels.2

After seeing ratios push to the wider levels in April, there has been some positive momentum. Ratios now sit at 65% compared to Treasurys in the 5-year space, 75% in 10-year, and 93% in the 30- year.2 Overall, there is a continued steepening of the yield curve in both municipals and Treasurys, which means short-end securities are performing better then longer end ones. There continues to be volatility due to economic expectations, tariffs and the One Big Beautiful Bill Act, which contains tax and spending policies that form the core of the current administration’s second-term agenda. There is ongoing concern about inflation and deficits, which has caused the long end of the treasury curve to get cheaper.

Some of this policy could potentially have a negative impact on hospitals due to Medicare and Medicaid cuts. In addition, there are some policies that could impact higher education and how their endowments could be taxed.

Moving out of tax season and into the June and July reinvestment period has stabilized the tax-exempt fixed income space. During this time frame, there is typically an increase in maturing bonds and coupon payment to reinvest, which has enabled the market to digest the heavier supply and even outperform in certain parts of the curve.

Even though tax exempts are not quite as attractive as they were at the end of the first quarter overall, the taxable equivalent yield on longer paper is something worth noting, and it could bring better flows into the long end of the curve. There are currently nominal yields that do not come very often in the longer tenors, and this should give the market some stability at these more attractive ratios.  

Commodity Derivatives[***]

Like most asset classes, the energy complex was heavily influenced by geopolitical events and tariff impacts in the second quarter. Conflict in the Middle East was quickly priced in, sending crude higher by roughly $10 per barrel as West Texas Intermediate (WTI) peaked at $75.14 and Brent peaked at $79.39.3 But that move was just as quickly priced out as tensions eased without any significant damage to production and export facilities. Option prices did remain higher for a little longer, but implied volatilities have since moved lower as the markets removed the need to hedge tail risks. 

Tariffs, however, did have a lingering impact. Spot prices for crude and natural gas, along with their respective 2026 calendar-year strips, ended the quarter lower as markets forecasted that lower economic activity would drive lower demand for energy. The timing of the move paints a slightly different picture, as the decline occurred just within the month of April. Prices recovered throughout May and June as the economic effects from tariffs seem to either be delayed or not impactful. The franchise saw consumers adjusting forecasts higher for their fleet usage and taking advantage of the lower prices to lock-in diesel and gasoline volumes to meet the adjusted demand. 

Interest Rate Derivatives[***]

The second quarter of 2025 started with the dramatic market volatility sparked by tariff policy. Stocks sold off and interest rates initially rallied on the proposed tariffs, which were much higher than anticipated. However, the rates rally was short-lived, and by April 4, a “sell the U.S.” bias emerged, sending the dollar lower and treasury rates much higher. Swap spreads, which represent the difference between swap rates and Treasury yields, saw unprecedented daily moves lower as Treasury yields increased relative to swap rates. A bear raid on Treasuries seemed to be in play. On April 9, a 90-day tariff pause was announced, and stocks and Treasury yields were able to stabilize.

In the weeks that followed the tariff pause announcement, the markets were focused on economic data releases, watching for any potential signals of inflation or growth impacts that the tariff announcements may have caused. Through much of May, the rates markets focused on the potential inflationary impacts of the tariffs and associated supply chain disruptions. That sentiment shifted in mid-June, helped by dovish Fed speak and a flare-up in the conflict in the Middle East. However, de-escalation of the conflict and firm growth and inflation data once again had rates moving higher through early July.    

Looking ahead to the second half of 2025, the details of the final tariff deals will play a large part in where rates go after August 1. The markets will continue to be focused on economic data releases as participants attempt to read when the Fed will resume their rate cuts, with expectations currently at approximately two cuts by year-end. Any positive impacts to inflation would continue to push cuts out further into the future and would keep upward pressure on rates. Likewise, any destruction to growth or employment could cause the Fed to cut sooner and would likely result in lower interest rates across the curve. 

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Sources

1.  Bloomberg US Mortgage Backed Securities (MBS) Index

2. The Municipal Market Monitor(TM3)

3. Bloomberg Commodity Derivatives

Additional Disclosure: 

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