Bond Market Outlook Q3 2021

Bond Market Q2 Review & Q3 Outlook 2021

July 13, 2021
by Chris Keith, Senior Vice President, Fixed Income Manager
wdt_ID There’s a disconnect between economic data and the bond market
1 Bonds bounced back in Q2
2 • Inflation is spiking, but we’re not panicked
3 • Taper-talk will dominate Q3

What a difference a quarter makes! The Aggregate Bond index produced a positive return of 1.83% in Q2, and both momentum and performance in the bond market changed for the better.

Just three months ago, bond investors had been rattled by the worst quarterly performance in decades, with the index dropping 3.37%. As we said at the time, Treasury and other high-quality bonds were overbought during the pandemic and due for a correction. But the pendulum swung too far—creating a buying opportunity. Enticed by higher yields, buyers returned this quarter to “buy the dip,” spurring a turnaround. We’ve got a long way to go before we’re in the black for the year, but Q2’s rebound took the sting out of Q1’s disappointment.

Meanwhile, there’s a seeming disconnect between the data we’re getting on the state of the economy and the mood of bond investors. Inflation, measured by the Consumer Price Index (CPI), recently reached 5.0%—a level we haven’t seen since the summer of 2008—yet bond yields are dropping! Such action is puzzling because you’d expect rising inflation to lead to higher bond yields (and, therefore, falling bond prices and further declines in the bond index). Yet, just us inflation was rising over past few months, the yield on the 10-year Treasury benchmark fell and its price increased. The yield dropped to 1.45% to close Q2 (versus 1.74% for Q1).

How do we explain this behavior? In my view, bond investors are looking past the economic data of recent weeks and taking a long-term view of the state of the economy. And those investors—myself included—see reasons to be skeptical about its long-term growth prospects. The economy stands in far better stead today than during the pandemic, but obstacles remain. As I pointed out in a recent podcast, much of the inflation uptick last quarter was caused by government stimulus measures (which are now expiring) and supply chain bottlenecks (which are now loosening). Without sustained wage increases, the high inflation we experienced in Q2 will have trouble sticking around. I give Federal Reserve Chair Jay Powell credit for holding on to his belief that the recent bout of elevated inflation is transitory. His unwavering stance has been criticized by some. Ultimately, I believe he’ll be proved right.

I’m not worried about interest rate hikes in the near-term, but I do think the Fed will start winding down their asset purchases. As we move into Q3, discussion among central bankers about tapering may cause market jitters, though I think they’ll prove fleeting. Bond investors can expect ample guidance from the Fed about any such plans.

In short, we may see further peaks and valleys in Q3, but you can safely keep your wheelbarrow in the garden shed. If something does occur to upset the bond market, it’s not going to be hyperinflation.

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