Dose of rates realism in the wake of the FOMC

Part 5

Why the bond market outlook is volatile with a downside looming

Volatility ahead

On the one hand, the fundamentals seem to be in place for a strong bond market (LQD). But on the other hand, there are several persisting factors against bond market strength.

US Fixed Income Markets 2013-09-24Enlarge Graph

The upside: Steady volumes and diminished tapering fears

There’s strong investor appetite, as shown by the inflows and steady volumes receiving a warm market reception. Plus, the tapering fears that had dominated the market over the past month have dissipated somewhat and given bond yields some breathing room. Also, budget talks may buy bonds some more rally time since a government shutdown would spark a flight to safety, and once again, bonds would be the favorite hideout.

Downside: Short-term upside “what-ifs” and medium-term sure threats

But on the other hand, if Congress reaches a last-minute agreement on the budget (which it probably will), then bond prices will sink sharply and fast, leaving no reaction time for investors. Plus, once October gets closer, tapering expectations will once again dominate the market tone and put downward pressure on bond (BND) prices.

Budget talks could provide gains for bondholders, but this is more of a maybe and would only be temporary. The tapering threat is a sure thing, yet with uncertain timing. But we’re quickly closing in towards an October date…

Take the gains and run

While there may be some opportunity in the short term, whether investors can take advantage of it will depend entirely on market timing—both going in and getting out. The downside in the short term may be high, and in the medium term, it’s almost certain. So the bond market, whether investment-grade (BND) or high yield (HYG), isn’t likely to be an investor-friendly place over the next couple of months.

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