2Q25 was marked by heightened policy uncertainty in the U.S., with debates over fiscal sustainability, aggressive trade measures, and growing pressure on monetary policy shaping market sentiment. Nevertheless, the market staged an astounding comeback, which played out against a complex policy backdrop highlighted by a U.S. credit downgrade and heated budget negotiations in Washington.

Policy

In mid-May, the U.S. government was downgraded by Moody’s to Aa1, making it the last of the “big three” major rating agencies to remove the U.S. from its highest rating. The announcement came just as Congress began the budget reconciliation process and the One Big Beautiful Bill (OBBB) started moving through the House. Moody’s cited concerns over the inability of consecutive U.S. administrations and Congress to reverse the trend of persistent annual deficits, the growing size of government debt, and rising interest costs. Its rationale included a base case in which the 2017 Tax Cuts and Jobs Act would be extended, potentially adding trillions to the fiscal deficit over the next decade.

By quarter-end, the Senate advanced toward a final version of the OBBB that prioritized tax relief and spending cuts. The bill’s potential impact on the deficit was hotly debated, with long-term estimates varying widely. The Congressional Budget Office (CBO) projected that the Senate’s version could increase the federal deficit by over $3 trillion over the next 10 years, while the White House’s preferred analysis, produced by the Council of Economic Advisers, projected a reduction of $4.5 trillion over the same period. The Trump administration argued that its broader policy measures would offset the gap between revenue and spending, citing fiscal policy changes, deregulation efforts, discretionary spending cuts, and tariff revenues.

Key Trends in the Economy in 2Q25

Liberation Day marked the start of 2Q25 and set off a pattern that market participants soon dubbed the “TACO trade,” for “Trump always chickens out.” The president’s executive order imposed a baseline 10% tariff on all imported goods, along with additional reciprocal tariffs targeting specific countries. In response, the S&P 500 plunged, suffering one of its worst two-day declines in 75 years, with a drop of 10.5%, while long-term U.S. Treasury yields moved higher. Seven days later, the White House announced a 90-day pause on the reciprocal tariffs, which acted as a catalyst for a strong market rebound. Similarly, on May 12, the U.S. and China announced a 90-day pause on opposing tariffs, which had escalated to triple-digit levels. Investors appeared increasingly attuned to the White House’s tendency to pivot on trade policy, as the S&P 500 continued to rally and ultimately delivered a strong recovery (+10.9% QTD, +6.2% YTD). A range of other tariffs remains in place, including fentanyl-related duties on China, Canada, and Mexico, as well as duties on steel, aluminum, automobiles, and small dollar imports from China.

The White House’s pressure on the Federal Reserve intensified, with markets reacting sharply to the president’s critical comments regarding Fed Chair Jerome Powell’s effectiveness. The administration argued that a lower Fed Funds Rate would help address fiscal challenges by reducing borrowing costs. Despite this pressure, the Fed maintained that it remains committed to its dual mandate and will continue to be data-dependent when determining future rate adjustments. June’s Federal Open Market Committee meeting highlighted that inflation, while moderating, remains somewhat elevated against a backdrop of solid economic activity and low unemployment. Its summary of economic projections suggested stagflationary pressures in the near term, with inflation expected to rise and GDP growth to slow. The target rate was held at 4.25% – 4.50%, and the updated dot plot indicated two rate cuts by the end of 2025 and a longer-term target rate of 3.4% by 2027.

U.S. Economy

While the Fed maintained its wait-and-see approach regarding the potential inflationary effects of trade policy, the latest inflation data showed little immediate impact. In May, headline CPI rose just 0.1% month-over-month and 2.4% year-over-year, while core CPI also increased 0.1% for the month and 2.8% annually. Inflation was primarily driven by higher food and shelter costs, which offset declines in energy, vehicle, and apparel prices. The Fed’s preferred measure, core PCE, rose 0.1% in May and 2.7% year-over-year, slightly above April’s reading.

The labor market remained on solid footing, with the unemployment rate holding steady at 4.2% in May, roughly the same level as one year ago. However, there were signs of softening: the U.S. economy added 139,000 jobs in May, down from 177,000 in April, with employment declining in manufacturing, retail, and government sectors. The latest Job Openings and Labor Turnover Survey (JOLTS) showed an increase in job openings in May, but hiring remained subdued.

U.S. GDP contracted at an annualized rate of 0.5% in 1Q (revised), driven primarily by net exports, which had an estimated –5% net effect on growth due to a surge in imports. Economic activity in 2Q suggested slowing momentum, with key surveys pointing to rising pessimism among consumers and business leaders. Consumer spending declined in May, reflecting the front-loading effect that occurred before Liberation Day, while building permits for new residential homes fell to their lowest level in five years. According to the Institute for Supply Management’s Purchasing Managers’ Indices (PMIs), both the manufacturing and services sectors remained in contractionary territory during the quarter. The Conference Board’s Consumer Confidence Index declined in June, revealing rising concerns about current and future business and labor market conditions, with tariffs and inflation cited as top worries.

Currencies and Global Economy

The U.S. dollar spiraled lower as the trade war escalated, marking one of its worst starts to a year since 1973, when the U.S. left the gold standard. The ICE U.S. Dollar Index, which measures the dollar against a basket of six major currencies, fell roughly 10% year-to-date. This sharp decline reflected a mix of factors, including expectations of Federal Reserve policy easing and lower yields, concerns over U.S. fiscal sustainability, and efforts by foreign central banks to diversify reserves as part of a broader push to reduce reliance on the dollar. 

The OECD estimates global growth will slow to 2.9% in 2025 from 3.3% in 2024, reflecting headwinds from trade barriers, tightening financial conditions, and ongoing policy uncertainty. The euro zone showed signs of a modest recovery, with GDP expanding by 0.6% quarter-over-quarter in 1Q, supported by improving business sentiment. The European Central Bank lowered its key policy rate for the eighth time as inflation approached its 2% target. In Japan, growth momentum remained mixed as 1Q GDP was revised upward but stayed in contractionary territory. Inflation remained above the 2% target, supporting arguments for continued gradual policy normalization.

Emerging markets saw mixed performance, with some countries benefiting from stable demand and improving investor sentiment, while others faced renewed currency volatility and local inflation pressures. China continued to struggle with weak domestic demand and a fragile property sector despite ongoing stimulus efforts. Although the U.S. and China have agreed on a trade framework, tariffs remain significantly higher than historical norms, continuing to pressure Chinese exporters. The volatility of oil and liquefied natural gas prices increased as the Israeli-Iranian conflict escalated, including a U.S. airstrike on Iranian nuclear sites and Iran’s missile retaliation. Despite fears of a major supply disruption through the Strait of Hormuz, the route remained open, and oil prices ultimately fell back below $70 a barrel after a brief surge.

The Fourth of July was a fitting symbolic close to a volatile 2Q. The holiday offered a moment to pause and reflect on a period marked by a remarkable market rebound despite a mixture of policy and geopolitical uncertainties. Domestically, budget measures aimed at tax relief and spending cuts were rushed through Congress, while evolving tariff policy kept investors guessing as trade tensions repeatedly escalated and de-escalated. The Federal Reserve’s independence drew increased scrutiny amid political pressures, and the dollar continued its decline. Abroad, geopolitical risks intensified as conflict spread further in the Middle East. Against this backdrop, it’s essential to remember that markets can quickly move from fear to optimism, often in ways that defy short-term headlines. As always, Callan encourages investors to maintain a long-term perspective and a prudent asset allocation with appropriate levels of diversification.