A Quarter to Remember

Not every quarter begins by rewinding the terms of trade to the 1930s. The shock – a fundamental change of the economic order – sparked frenetic trading sessions across global financial markets. Calm did not prevail until the White House announced a 90-day pause on tariff implementation. But global trade turmoil was just the beginning. Debates over deficit-financed tax and spending measures ignited debt-sustainability concerns, and Moody’s stripped the U.S. of its coveted triple-A credit rating. To top it off, geopolitical risk surged as the goal of a quick peace agreement in Ukraine failed to materialize, and tensions in the Middle East culminated in U.S. airstrikes on Iranian nuclear facilities, sealing Q2 2025 as one memorable quarter.

The April 2, 2025, tariff announcement pushed policy uncertainty to unprecedented levels. As in prior risk-off episodes, Treasury yields initially rallied. But once investors repriced institutional risk and reassessed potential damage to U.S. policy credibility, Treasuries sold off. In just days, both nominal and real 10-year yields rose 50 basis points (bps)¹. Exhibit I shows a modest quarterly change of +9bps in the 10-year real yield, but this move disguises the underlying volatility: The magnitude of daily yield movements in Q2 totaled 276bps, well above Q1’s 198bps. (Exhibit Ib.)

Market-implied inflation expectations, breakevens, reversed most of the increase experienced since the 2024 election. In the absence of any impact from tariffs on realized inflation, breakevens drifted down, especially shorter maturities. Longer-maturity breakevens, which reflect inflation expectations over the long term plus an inflation risk premium, remained almost unchanged in Q2.

Treasury Inflation-Protected Securities (TIPS) returned 0.48% in Q2 2025, bringing the year-to-date total return to 4.67%. In 2025, TIPS outperformed nominal Treasuries by 0.88%, the Bloomberg Aggregate Bond Index (Agg) by 0.65%, and investment-grade corporate bonds by 0.50%. Sustained outperformance and perceived inflation risks kept net flows into TIPS-related exchange traded funds positive for a second consecutive quarter, reaching $7.3 billion for the year.

The Federal Reserve (Fed) held rates steady throughout Q2. Some Fed officials expressed their willingness to lower rates as soon as July, but most members of the Federal Open Market Committee (FOMC) stood behind Chair Jerome Powell’s patient and data-driven approach. By quarter end, investors in fed fund futures markets priced two rate cuts by December 2025 and almost 125bps in cuts over the next 12 months. For comparison, at the beginning of 2025, investors priced 43bps in cuts for the year.

Positioning and performance

The Bloomberg U.S. Treasury Inflation-Linked Bond Index, the benchmark, represents TIPS with at least one year until final maturity. Our expected returns framework, illustrated in Exhibit IIa, shows the sources of value across these securities. Note that in addition to real yield, roll-down and inflation are important sources of expected return. Inflation contributes to each bond’s expected return equally, not giving an advantage to any one of them over the others. Roll-down return depends on the slope of the real yield curve, which ranged between 40bps and 50bps in Q2, in contrast to -40bps two years ago. Therefore, today’s 10- to-15 positions underlying our strategies, concentrate in the intermediate part of the curve, maximizing roll-down opportunities.

The resulting term structure positioning depicts a curve steepener between the intermediate and long parts of the real yield curve. Furthermore, the shift from short to intermediate maturities extended the portfolio’s duration slightly ahead of the benchmark’s duration, as seen in Exhibit IIb.

Our positioning generated 7bps of performance over the benchmark in Q2, bringing year-to-date excess return to 19bps. Both roll-down and duration have contributed to performance.

Macroeconomic conditions and policy

Economic policy uncertainty has declined from its all-time high, closing some of the gap between sentiment and hard economic data. In addition to sentiment improving, the economy remained growing throughout Q2. The New York Fed’s Nowcast, a real-time estimate of economic growth, averaged 2.3%.

The labor market added 449,000 jobs in Q2, bringing the first-half 2025 total to 782,000. Although these levels are on track with average job creation in the last 12 months, they are far behind first-half 2024, when the economy added almost one million jobs. Furthermore, the details of the most recent report illustrate a more nuanced picture. For instance, of the 147,000 jobs added in June, only 83,000 jobs are in the private sector, and 59,000 of them are in the healthcare sector.

The anticipated inflationary impact of tariffs has been muted thus far. Realized annual core inflation has stayed between 2.7% and 3% for several months. One reason might be that suppliers accumulated inventories in Q1 and can offer goods at prices that still reflect pre-tariff costs. It is also possible that businesses are not fully passing through their higher costs to consumers while the final trade regime remains uncertain. Both survey-based and market-implied measures of short-term inflation expectations had risen before April, but once the White House announced the 90-day pause in the application of reciprocal tariffs, they moved down closer to 3%.

The housing inflation complex in the Consumer Price Index (CPI), also known as shelter, constitutes more than 45% of core CPI and continues to drive core inflation. It has contributed 0.34% of the 0.42% inflation added in the last three months. Running at an annualized rate of 3.1%, housing inflation has moderated, approaching its 3% pre-COVID long-term average.

The Fed is in a difficult position, balancing inflationary risks from tariffs against economic activity signals. Tariffs are taxes that increase the cost of imported goods, which add inflationary risks. Uncertainty about where tariffs will settle postpones business activity, adding risks of an economic slowdown. It might be premature to talk about stagflation, but the preconditions exist. The current wait-and-see mode of the Fed indicates that for now policy makers are focused on guiding inflation toward the 2% target before cutting rates. Chair Powell has acknowledged that rates are “somewhat restrictive” but has not provided guidance on the timing of future cuts. June’s Summary of Economic Projections shows the median FOMC member expects two rate cuts in 2025.

Conclusion

During Q2 2025, TIPS remained strong in turbulent macroeconomic conditions and financial markets full of policy uncertainty. For the year, they remain ahead of nominal Treasuries, the Agg, and investment-grade corporate bonds. Stable long-term breakevens, and positive excess returns cement TIPS as a durable inflation hedge and a stabilizing force within diversified portfolios. With inflation risks far from extinguished, and breakevens trading at discount to realized core inflation, TIPS are well-positioned to absorb volatility while delivering inflation-adjusted income. The term structure remains supportive, and valuations strong. The quarter to remember has reminded investors that protection against inflation uncertainty is essential.