Bond Market Q2 Review & Q3 Outlook 2021

Chris Keith

Senior Vice President, Fixed Income Manager

What a difference a quarter makes! The Aggregate BondA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates. 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 bondsA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates. were overbought during the pandemic and due for a correction. But the pendulum swung too far—creating a buying opportunity. Enticed by higher yieldsYield is a measure of the income on an investment in relation to the price. There are several ways to measure yield. The current yield of a security is the income over the past year (either dividends or coupon payments) divided by the current price., 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 yieldYield is a measure of the income on an investment in relation to the price. There are several ways to measure yield. The current yield of a security is the income over the past year (either dividends or coupon payments) divided by the current price. 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.

This material is distributed for informational purposes only. The investment ideas and opinions contained herein should not be viewed as recommendations or personal investment advice or considered an offer to buy or sell specific securities. Data and statistics contained in this report are obtained from what we believe to be reliable sources; however, their accuracy, completeness or reliability cannot be guaranteed.

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